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In a perfectly efficient market, all investors would act rationally and consider all available information when deciding on their investment choices.
Unfortunately, this is not the case. It's been evident by the internet stock frenzy over the last couple of years that a lot of investors DO NOT behave rationally when it comes to making their investment decisions.
There is a field known as Behavioral Finance which attempts to understand and explain how emotions influence investors and their investment decisions. We're gonna take a look at some of the things that may influence investors to act irrationally and cause them to underperform:
Experts have found that people put different weights on gains and losses. Most people are much more distressed by losses than they are happy with equivalent gains. In fact, $1 lost is twice as worse as the pleasure of a $1 gain.
This is one of the reasons why some investors will avoid selling a poorly performing stock even when they feel it will continue going down. They don't want to face the pain involved with a loss.
Fear of Regret
The fear of loss goes hand in hand with the fear of regret. Investors don't want to go through the pain of having made an error of judgment. Some investors feel embarrassed having to report a loss to the IRS and their accountants.
Acting irrationally like this will allow investors to continue to keep a losing investment.
In order to reduce the fear of regret, many investor will simply follow the crowd by investing in popular stocks, rationalizing that if they lose, they will not be the only one to have made a bad decision.
Recent Trends
Experts have also found that investors put too much weight on recent experiences and trends to determine the future. When the market is performing well, most people expect it to keep performing well in the near future and vice-versa.
Simply take a look a the excitement that Dow 10,000 has caused. Many are predicting that the Dow will now reach 15,000 soon. But that wasn't the case just last year when the Dow had corrected a bit. Most were saying that a market crash was imminent!
The same thing happens with mutual funds. Last years best performers always have new investors flocking to them thinking that just because they did well last year, they'll do it again. Unfortunately, this rarely turns out to be the case.
Too Much Confidence
Another trait that humans possess which may have an adverse reaction to their investment decision is the tendency to gamble. Most people will not remember their failures as they remember their gains, leading to over confidence in their abilities.
This is why people addicted to gambling have a hard time quitting. They remember their success more than their failures, so they keep on gambling and taking high risks. People who are over confident in their ability to pick stocks may fall into the habit of day trading, which has an 80% failure rate.
Moral of the Story
It's important to realize what type of emotional traits you have that can hinder your investment decisions. Realize that stocks have always had an upward trend and that short-term influences are not going to make or break you as long as you invest for the long-term.
Gains & Losses
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