The Cycle of Investor Emotion

March 28, 2025

On the heels of Dan’s latest newsletter regarding the emotional nature of markets, I want to dive a little deeper into the psychology at work. Not only is there plenty of anecdotal evidence suggesting humans make many of their financial decisions based on emotion, there’s a whole field of study called behavioral finance that reveals why this is.

Behavioral finance identifies common cognitive and emotional biases that impact humans’ financial decisions. Biases are irrational assumptions or beliefs that affect our ability to make a fact-based decision. Not only do they impact personal financial decisions, these biases can also drive stock market fluctuations on a large scale (as we’ve recently seen). Specifically, the bias “herding” refers to the tendency of investors to follow the actions of the group, rather than making independent decisions based on their own analysis.¹ This is deeply rooted in human psychology. A study by researchers at the University of Leeds found that when just 5% of a crowd seemed to know where it was going, the other 95% of people followed along without realizing it.² As social creatures, our nature is to stick with the group, assuming others know something we don’t. In investing, when herd mentality strikes, the result can be widespread panic selling or market bubbles (think GameStop Frenzy of 2021).³

Human emotions and biases often guide our investment decisions in the worst ways, especially during a down market. Highlighted below is an illustration of “The Cycle of Investor Emotions”:

Cycle of investor emotions

The takeaways here:

• As markets climb, so does the investor’s excitement. But a good investor will see that an investment made at the height of market prices has less potential for future growth.
• As markets fall, the investor’s fear and anxiety take over. Some investors panic and pull out of the market. But a good investor will see that investing in a down market is generally an opportune time.⁴

Along these same lines, Warren Buffett once advised investors “to be fearful when others are greedy and to be greedy only when others are fearful.” Easily said, but extremely hard to do.

In short, being a good investor requires patience, discipline, solid research and sound advice. It is not easy to achieve, but self-awareness of our natural and emotional tendencies is the first step toward successful investing.

- Carrie McDonnell

1. https://www.cambridge.org/core/journals/behavioural-public-policy/article/behavioral-finance-impacts-on-us-stock-market-volatility-an-analysis-of-market-anomalies/D1CEF34141D03D8BECB2AE42467166B3
2. https://www.schwabassetmanagement.com/content/herd-mentality-bias
3. https://thedecisionlab.com/insights/finance/the-sheep-in-the-stock-market
4. On a side note, One Day In July does not believe in market timing, as it is impossible to know when a cycle has reached peak or trough, except in retrospect. Instead, we believe it’s typically in the client’s best long term interest to get their money invested and stay invested. https://www.onedayinjuly.com/the-cycle-of-investor-emotion