Investor psychology is the second chapter in a five-part series exploring the common narratives surrounding the idea of “investing for the long term.”
Key Takeaways
In the first article, we identified the next obstacle investors must overcome: themselves.
You can understand valuation models, master financial metrics, and learn the principles that supposedly determine investment success. Yet you can still give a significant portion of your returns back to the market for one simple reason: you are human.
Human beings are naturally wired to respond to danger, follow the crowd, and place greater weight on recent experiences. Those instincts may have helped our ancestors survive, but they can become destructive when applied to an investment portfolio.
There is another problem, too. Markets can gradually train investors to develop certain reactions until those behaviors begin to feel like sound financial judgment.
One enemy is how we are naturally wired. The other is how the market has conditioned us.
This is where investor psychology becomes especially important.
You May Be Your Own Biggest Investment Risk
One of the most uncomfortable realities in investing is that the average investor often earns less than the very funds they own.
A fund may generate a strong return, yet the investor holding that fund captures a smaller portion of it. This pattern has appeared repeatedly over time.
Morningstar’s annual “Mind the Gap” study highlights this behavior. In its 2025 edition, covering the decade through the end of 2024, the average dollar invested in U.S. funds earned roughly 7.0% annually, compared with approximately 8.2% for the funds themselves.
That difference amounts to around 1.2 percentage points per year.
The shortfall is not necessarily caused by excessive fees. Much of it comes from investor behavior: buying after prices have already risen, selling after markets have already fallen, and repeating the process.
At first glance, a 1.2% annual difference may seem insignificant. Over 30 years, however, the effect becomes substantial. On an initial $100,000 investment, such a gap can amount to roughly $300,000 in lost wealth.
Of course, researchers debate how much of the performance gap is caused by poor timing versus the normal mechanics of when investors contribute or withdraw money. Not every percentage point can be blamed entirely on emotional decision-making.
But one principle remains clear: emotional trading tends to hurt investors, and excessive trading generally makes the problem worse.
The investors who interfere with their portfolios the least often have the best chance of retaining more of their investment gains.
The Emotional Cycle That Repeats
Why do intelligent and experienced investors repeatedly buy near market highs and sell near market lows?
Because the decision often feels completely reasonable at the time.
Market cycles tend to follow a familiar emotional pattern. After prices rise for an extended period, confidence grows. Gains appear easy, other investors seem successful, and optimism spreads.
Eventually, that confidence can become euphoria—the stage associated with some of the highest financial risk.
At the opposite extreme, after a major decline, investors become discouraged and fearful. They may decide that stocks are simply too dangerous and swear off investing altogether.
Ironically, that period of despondency can coincide with some of the market’s greatest opportunities.
The problem is that investor psychology often points in the wrong direction.
Market veteran Bob Farrell summarized the phenomenon decades ago: investors tend to become most enthusiastic near market tops and most reluctant near market bottoms.
That does not happen because investors are unintelligent. It happens because rising markets feel safe, while falling markets feel dangerous.
Howard Marks has made a similar observation: when virtually nobody believes markets are risky, most potential buyers may already be invested, leaving fewer new buyers to push prices higher.
Four Psychological Biases That Can Damage Returns
Investor behavior is influenced by numerous cognitive biases, but four are particularly important when it comes to investment decisions:
- Loss aversion
- Recency bias
- Confirmation bias
- Herding
Understanding these biases is the first step toward recognizing them before they affect your portfolio.
1. Loss Aversion
Loss aversion is one of the most powerful forces influencing investors.
Research associated with Daniel Kahneman demonstrated that people generally experience the pain of losing money much more intensely than the pleasure of gaining the same amount.
That imbalance can make investors reluctant to sell losing investments.
Imagine a stock that has fallen 40%. Selling would make the loss official, so investors often continue holding the position in the hope that it eventually recovers.
Instead of making a rational assessment of the investment’s future prospects, they become emotionally attached to avoiding the realization of the loss.
The problem is that refusing to sell does not eliminate the loss. It simply keeps capital tied up in the position.
A better approach is to establish your investment criteria and exit rules before purchasing an asset. Decisions made in advance are usually less influenced by fear, hope, or regret.
Selling then becomes part of a predefined process rather than an emotional reaction.
2. Recency Bias
Recency bias occurs when investors assume that recent events will continue indefinitely.
After an asset has delivered impressive gains, investors may begin to believe that further gains are almost inevitable. That perception often attracts even more money after prices have already risen substantially.
The same phenomenon occurs in reverse.
Following a severe decline, investors may conclude that the asset is permanently damaged and avoid it even when valuations have become more attractive.
As a result, investors can repeatedly buy yesterday’s winners at elevated prices and sell yesterday’s losers after prices have already declined.
One way to counter this tendency is to expand your time horizon.
A three-year period of strong performance can look very different when compared with two decades of historical data. Rather than focusing primarily on recent returns, investors should consider valuation, long-term fundamentals, and where the current price stands relative to historical norms.
Historically, assets that are inexpensive and unpopular have often offered more attractive opportunities than assets that are already expensive and universally admired.
3. Confirmation Bias
Confirmation bias can be particularly dangerous because it often looks like thorough research.
Once investors own an asset—or become emotionally committed to buying it—they naturally begin searching for information that supports their existing view.
Bullish articles receive attention while bearish arguments are dismissed. Social media feeds become increasingly personalized, creating an echo chamber where investors hear mostly from people who agree with them.
The danger is that this process can create the illusion of research without genuine challenge.
Instead of testing an investment thesis, investors may simply be collecting evidence that makes them feel correct.
A useful countermeasure is deliberately seeking out the strongest argument against your position.
Find someone intelligent who believes you are wrong and seriously consider their reasoning. If you cannot explain the opposing argument accurately, you may not fully understand your own investment thesis.
Reducing the noise from social media and avoiding ideological echo chambers can also improve decision-making.
4. Herding
Herding is one of the oldest human instincts and can be extremely costly in financial markets.
Throughout human history, staying with the group often increased the chances of survival. In investing, however, following the crowd does not automatically provide safety.
When everyone is buying an increasingly expensive asset, joining the crowd may feel sensible.
When everyone is selling, standing aside can feel reckless.
But markets often become most vulnerable at extremes, precisely when the majority appears most confident.
When a particular investment becomes popular, obvious, and universally recommended, that should not automatically make you more comfortable.
It should make you ask harder questions.
When an investment decision feels effortless and everyone appears to agree, that may be the moment when additional scrutiny is most valuable.
Markets Can Train Investors to React Automatically
Investor psychology is not only about natural human instincts. It is also shaped by experience.
The concept is similar to Pavlov’s famous conditioning experiments. Repeatedly pairing a signal with a reward can eventually produce an automatic response.
Financial markets can create a similar pattern.
Over many years, investors may see market declines followed by recoveries. Policymakers intervene, liquidity returns, economic conditions improve, or momentum eventually turns upward.
After experiencing this cycle repeatedly, investors can become conditioned to respond automatically whenever markets fall.
The sequence becomes:
Market falls → buy the dip → market recovers → repeat.
Eventually, investors may stop analyzing whether the current situation is actually different.
This can create a form of moral hazard—the assumption that someone or something will eventually protect you from the consequences of taking excessive risk.
The danger is that a strategy can appear increasingly intelligent simply because it has worked repeatedly in the past.
Every successful dip-buying experience reinforces confidence in the strategy.
But conditioning becomes particularly dangerous near market peaks, after investors have enjoyed a long sequence of successful recoveries.
The problem is that eventually a decline arrives that does not quickly reverse.
The Investment “Awards” You Do Not Want
Once natural instincts and market conditioning are combined, investors can develop a collection of behaviors that look like virtues but often damage long-term returns.
Being loyal to a losing investment is not the same as being loyal to a sound investment process.
Taking the greatest possible risk is not automatically the same as identifying the greatest opportunity.
And claiming to be a “long-term investor” only when an investment is underwater may simply be a way of rationalizing a bad decision.
As investor Jeremy Grantham has argued, investors are rewarded for buying assets at attractive prices—not simply for accepting greater risk.
A useful way to think about portfolio management is to compare it with gardening.
A good gardener does not keep a dying plant simply because they have become emotionally attached to it. They remove what is failing, prune what has become excessive, and create more room for healthy growth.
A portfolio requires similar maintenance.
Selling a losing investment is not necessarily an admission of failure. Sometimes it is simply good portfolio management.
There is no reward for allowing weak investments to consume capital merely because you are unwilling to let them go.
How to Overcome Both Enemies
The biggest challenge with investor psychology is that you cannot simply switch off your instincts.
You cannot eliminate fear, greed, or emotional reactions through willpower alone. Nor can you instantly undo years of conditioning.
The practical solution is to create an investment process that operates independently of your emotions.
That means establishing rules before emotions take control.
Define your entry criteria. Determine your risk limits. Establish when you will sell. Review your portfolio based on predetermined principles rather than reacting to every headline or market movement.
The market does not necessarily take your money from you.
In many cases, investors give away their potential returns gradually through emotional decisions—buying because of greed near market highs or selling because of fear near market lows.
Perhaps the most valuable investment skill is therefore not finding the perfect analysis.
It is having the discipline to do nothing when your emotions are demanding action.
But discipline works best when it is supported by a clear process.
The next stage of understanding investor psychology is to examine the mathematics behind these mistakes.
A 50% decline requires a 100% gain simply to return to the starting point. The valuation you pay today can have a major influence on the returns you earn over the following decade. And for investors approaching retirement, the sequence in which returns occur can matter just as much as the average return itself.
Those are the numbers investors cannot afford to ignore.
