Market crashes are not new. They have happened for centuries and will continue to happen in the future. But if you look closely, the root cause behind many of these sharp declines is not always anchored in fundamentals – it’s often about human behaviour. The way we react as individuals and as crowds plays a huge role in fuelling extreme market movements.
This is where Investor Psychology and the discipline of Behavioural Finance come into play. Together, they help us understand why smart investors often do dumb things during unstable markets.
In this article, I’m going to break down 5 of the most damaging behavioural biases that directly contribute to losses during a Stock Market Crash. At the same time, I’ll also profile some real historical examples and give practical insights on how to keep emotions in check when volatility rises.
Why Do Markets Crash in the First Place?
Before we jump into the biases, let’s pause here. A market crash typically occurs when prices of stocks, bonds, or other financial instruments fall significantly in a very short span of time. Triggers could be economic shocks, banking failures, geo-political tensions, or even over-leveraged bubbles suddenly bursting.
But here’s an important truth: markets don’t just fall because of “bad news.” They crash because humans react collectively to that news. Fear spreads faster than logic. Hope converts into despair at lightning speed. And the crowd movement is often far more powerful than any piece of breaking information.
This is why studying Fear and Greed cycles is so important. They are like tides, constantly shaping market waves.
“Markets are driven not just by earnings or interest rates, but by people’s perception of them.” – A timeless reminder from behavioural economists.
Bias #1: Loss Aversion – Why Losses Hurt More Than Gains
Perhaps the most documented bias in Behavioural Finance is Loss Aversion. Simply put, humans feel the pain of losing twice as strongly as the joy of an equal gain.
Think about this: if you make ₹10,000 in profits, you feel pretty good. But lose ₹10,000 and suddenly your entire week feels ruined. This imbalance distorts investor decision-making.
During a Stock Market Crash, this bias compels people to sell too quickly. A small dip feels unbearable, and instead of holding on to good companies, they hit the sell button in hopes of preventing “further damage.” Ironically, this very behaviour often leads them to exit at the bottom.
Real Example:
In March 2020, at the start of COVID-19, the NIFTY 50 in India fell nearly 40%. Investors panicked, pulling out investments in droves. But those who gave into lower tolerance for risk ended up missing a strong rebound that followed only months later.
Bias #2: Panic Selling – The Power of Herd Behaviour
Nothing illustrates Panic Selling better than a crowd stampede. One person starts running and suddenly, everyone believes there must be danger. The same happens in financial markets.
In psychology, this is linked to herd mentality. We assume others know something we don’t, so we copy their actions. Fear of missing out (FOMO) in rising markets mutates into fear of total ruin when markets crash.
Real Example:
During the 2008 Global Financial Crisis, panic was widespread. Even fundamentally strong companies saw their stock prices halved because investors as a herd sold everything. Those who stayed invested, however, witnessed one of the greatest recoveries of all time in the following decade.
Bias #3: Overconfidence – The Silent Enemy of Rational Investing
Ironically, sometimes investors lose money not because they are scared, but because they are overconfident. Overconfidence bias leads traders to believe they can “time the market” precisely.
When a market crash seems to be around the corner, such investors try shorting too aggressively, or they may deploy high leverage. If their predictions are even slightly wrong, the losses multiply.
In my own trading journey, I have seen this firsthand – people who made quick intraday profits suddenly gain “false courage.” But a single wrong bet wipes out months of gains.
The truth is markets are humbling. No one can consistently predict them, and accepting this fact is perhaps the biggest strength.
Bias #4: Anchoring to Past Prices
Anchoring means mentally “fixating” on a price point and refusing to adjust even when circumstances change.
For example, say an investor saw Reliance at ₹2800 before the correction. When it drops to ₹2400, they may hold off from buying because their anchor is the older ₹2800, assuming “the drop will continue.” Alternatively, they might hold on to a losing stock far too long, anchored to what they once paid for it.
This bias blinds us to reality – that a stock is worth only what it is trading at today, not yesterday. Anchoring decisions to past highs/lows can lead to misjudgement during a Stock Market Crash.
Bias #5: Fear and Greed Cycles
The most powerful driver of markets is not earnings or dividends – it’s raw emotion, swinging from one extreme to the other. And nothing captures this better than Fear and Greed.
When greed dominates, investors chase rising markets, even overvalued companies. But in a crash, fear takes the driver’s seat. Investors sell at irrationally low valuations, ignoring strong fundamentals.
Classic Example:
The Dot-com bubble of 2000 was a pure case of greed. Investors piled into any company with “.com” in the name, ignoring revenue models. When the bubble burst, fear took control, wiping out trillions in market cap.
How Can Investors Protect Themselves from These Biases?
Knowing about biases is step one. But controlling them requires deliberate actions:
- Have a Plan Beforehand – Pre-decide your asset allocation, stop-loss limits, and exit triggers. Emotional decisions should not be made in real-time.
- Automate Where Possible – Using SIPs or scheduled rebalancing cuts down emotional impulses.
- Seek Objective Counsel – A financial advisor or anchor (even a respected friend in markets) can provide rational perspective when emotions run wild.
- Keep Perspective – Remind yourself: every crash in history has eventually recovered. The only investors who permanently lost money were those who panicked.
Expert Insights on Investor Psychology
Behavioural scientists argue that markets are essentially giant mirrors of human Investor Psychology. In bull runs, we grow overconfident; in crises, we turn excessively pessimistic.
Seasoned investors like Warren Buffett have often summarized it well: “Be fearful when others are greedy, and greedy when others are fearful.” That single line is a defence against herd mentality.
Even today, large institutions run models based on mass behaviour. They know that when retail investors are gripped by Panic Selling, bargains emerge. In this way, professionals are often buying from those who let emotions control their finances.
Conclusion:
A Stock Market Crash is less about numbers on a chart and more about human behaviour on display. The 5 big biases – Loss Aversion, Panic Selling, Overconfidence, Anchoring, and Fear and Greed – show us that markets are as much psychological as they are financial.
As individual investors, the key isn’t eliminating these emotions altogether (which is impossible) but recognizing them in real-time and not letting them dictate actions in moments of chaos.
To succeed long-term, one must cultivate resilience, patience, and humility. Those three qualities guard you better than any chart pattern or algorithm when the storm arrives.