Psychological Considerations

In this section, the mental and psychological aspects of investing will be discussed. Despite the practical steps essential to successful investing, such as paying off high-interest debt and creating an emergency fund, there are other essential requirements before beginning to invest. Meeting these requirements will allow one to be unaffected by the various mistakes beginners tend to make when initially investing. 

Obtaining financial literacy and developing financial self-efficacy is essential for a beginner investor in order to enhance their success in the market. Financial literacy is the knowledge of basic financial terms that are essential for investing, while financial self-efficacy is the belief in one’s ability to be successful. Generally, one should first learn the new concepts of investing and then build upon this knowledge, leading to financial self-efficacy. A recent study conducted in Pakistan by Shoaib Khan, Faiq Mahmood, and Sahar Younas found that “attitude and self-efficacy were significant mediators for investors’ investment decisions” and that “they must have financial knowledge…” Additionally, a study found, via statistical analysis, “that financial literacy has a positive effect on stock investment intentions” (Putri). Investors with higher levels of financial literacy and self-efficacy were found to have a higher chance of investing confidently in the market. 

According to Derek Tharp, PhD of finance at the University of Southern Maine, “they’re not ‘financially literate’ until they have the ability and the confidence to actually put that knowledge to use for themselves.” Financial knowledge helps to build confidence and encourage investing. If a beginner investor builds this knowledge from the start, investing will seem relatively simple. This knowledge is built through various means, such as reading financial books. Beginners may also follow financial news – though this is generally discouraged, for long-term investors like John Bogle suggest tuning out market noise – thereby developing a familiarity with the various terms and concepts over time. Ultimately, financial literacy and self-efficacy are essential for investing and building these two characteristics will save one countless time and money. 

Psychologically speaking, a sound strategy, as discussed in the preliminary requirements, helps to prevent a variety of mistakes that often lead to large losses in the stock market. The Fear of Missing Out (FOMO) phenomenon “is when an individual fears they may be missing out on a significant financial opportunity. FOMO can have a significant influence on trading practices and can sway even seasoned financial investors leading to irrational exuberance” (Sternlicht). It is relatively easy to avoid this phenomenon by simply utilizing a strategy, particularly a long-term one, through extensive research. Before investing, one should ensure that they are fully confident long-term. By doing this, an investor will increase their self-efficacy while decreasing their self-doubt. 

Trading short-term with a lack of long-term perspective leads to day-trading addiction in beginners, which has “many similarities to gambling addiction” (Sternlicht). When one trades stocks often, it's frequently overwhelming and often leads to the disposition effect, which “is when our natural tendency to avoid failure distorts our ability to judge” (The Psychology). As a stock is going down, one might panic and sell it at its lowest price for it to later rise to new highs. This demonstrates another failure of short-term trading for beginner investors, all avoidable through a plan.  

Repetition bias occurs when investors believe that a certain event has a high likelihood of occurring, such as a stock crash. This leads them to be out of the market, waiting for it to happen. This is one of the worst mistakes that beginner investors make. “If you missed the market’s 10 best days over the past 30 years, your returns would have been cut in half” (Market Cycles). In order to avoid this bias, it is best to maintain a long-term perspective and continue to buy proven assets, trusting that they will go up over time, as supported by historical data.

Although having financial self-efficacy and confidence in one’s investing abilities is absolutely essential for successful investing, it is important that investors avoid overconfidence bias. This occurs “when we may tend to imagine that we are sometimes particularly good at ‘feeling’ the market” (The Psychology). This usually prevents an investor from developing a plan for investing. For example, someone who works in technology may be overconfident in predicting the growth of Apple, a popular technology company. This often leads to detrimental losses. Overall, is it essential to maintain a long-term perspective and maintain a strategy when investing in order to avoid these mistakes.

As discussed earlier, tuning out noise, and therefore staying away from day-to-day financial occurrences, is essential to successful investing. As investing has become more popular throughout the world, various media companies have formed to provide coverage on short-term events. According to Bogle, the primary purpose of the media is to “attract and hold” viewers; therefore, outlets must be entertaining. If they advocated the proven way to invest, which is relatively “boring,” there would be no audience. Thus, it is recommended that all beginner investors ignore daily events and stick to a reliable financial plan. 

The last portion of this section will explain the compounding effect; understanding it will allow one more confidence, demonstrating the topics discussed above. Compounding is essentially the exponential growth of a particular quantity over a period of time. The key to utilizing this fact is time, for time allows a particular asset to start multiplying increasingly as it passes. For investing, compounding often occurs when the gains of an asset are continually re-invested, and this usually occurs automatically. This allows for astronomical long-term gains that, when understood, greatly increase the self-efficacy and confidence of beginner investors.

Use the calculator below to better understand compound growth (the average annual interest rate of the market is about 10%):