We like to think of ourselves as rational beings, but when it comes to investing our own money we can all get a little loopy.
With so many non-professional investors participating in the markets a growing field of study called behavioral finance has set out to find what makes investors tick. Here is a compilation of some of the biggest head fakes:
Fear: This is the emotion that causes us to abandon the golden rule of investing: buy low, sell high. As we watch our investments fall in the context of a broader market downturn we create an apocalyptic scenario in our minds where it falls to zero, and we want to get out at any price. In reality, most stocks have what is called an intrinsic value, meaning they have some worth despite what the markets say. Unless a fundamental problem with the company itself has been revealed the market has probably overreacted.
Greed: This is the opposite of fear. We watch our investment rise in value with the broader markets and think the sky is the limit. Any investment can get to the point where the price does not justify earnings and eventually reason will kick in. As a general rule – what goes up must come down.
Attachment: We fall in love with an investment because it made us money in the past. We form an emotional bond with a company or fund like it’s a family member on a streak of bad luck. It’s just business. You need to ask, “What have you done for me lately?”
Stubbornness: We’re all the same when it comes to believing wholeheartedly in something and finding out it isn’t all that. It’s tough to admit you’re wrong, but stubbornly holding on to a dud can knock the stuffing out of your savings.
Helplessness: You see floor traders in a tizzy on the business channel and commentators talking at a fever pitch. You feel the need to do something – anything. These are usually the times when the best course of action is to do nothing. Keep in mind you’re in it for the long run. If it was a good investment when you bought it, it probably still is.
Optimism: Humans have a natural tendency to be optimistic. Believing in the best outcome is what gets us up in the morning. We’re not inclined to assume a negative outcome in any scenario, but it happens.
Herd mentality: If individual investment decisions are based on emotion, then the sum of all investors can be an emotional powder keg. Having your misguided optimism shared by millions of other investors can reaffirm your misguided optimism millions of times over.
Former U.S. Fed chairman Alan Greenspan coined the term “irrational exuberance” shortly before the technology meltdown in 2000 when tech stocks were trading at unsustainable levels. Herd mentality can turn to fear on a massive scale – when investors start trampling each other for the exits.
Belief in time travel: You can’t go back in time and make up for past losses. A lot of investment advisors say they saw this in clients after the meltdown of 2008 when broader equity markets lost more than half of their value. They tried to recover gains that took years to build in a few weeks, and ended up putting what they still had at risk.
Isolation: Say what you want about fees for investment advisors but at the very least they can be good sounding boards and provide impartial advice. Chances are they have many clients in the same situation. Look to your advisor for a sober second thought.