My Fleep:
Finance
Finance
Investors: Don't Shoot Yourself in the Foot With Emotional
Errors...Lessons from Behavioral Finance
Classic economic theory posits that investors always behave
perfectly rationally, in their own best interests. Emotions
are not involved.
You may be thinking, "That contradicts all my common
observations and experiences in life," and you would be
right. Nevertheless, classical economic theory is based on
a world full of rational, informed, iron-willed,
self-interested, consistent, and efficient actors.
Behaviorial finance, on the other hand, recognizes the
obvious: That investors are often influenced by emotion,
and that therefore they make illogical, inconsistent, and
ill-informed decisions, despite their best intentions to
act in their own self-interest.
There have been lots of studies in behavioral finance since
the field took off about 30 years ago. The studies--almost
astonishing in their variety--have attempted to find out
how most people really act when making financial decisions.
It turns out that we humans have several tendencies that
don't help very much when we are investing. They skew our
judgment. Here are the most common traits that lead to
investor self-sabotage:
--Failing to realize that the loss of an "unbooked" gain
really is a loss. Some investors only think it is a loss if
their account falls below what they originally invested.
They view an intermediate gain as not real, sort of like
playing with house money. Sorry, it was yours, and if you
didn't book it, you lost it.
--Failing to book a loss on a hopeless investment, hoping
that it will come back. This is called loss
aversion--people do not want to admit having made a
mistaken investment. Apparently, people feel more pain from
a loss than joy at an equivalent gain. They want to avoid
regret over the loss, so they just don't book it.
--Failing to take on enough risk, and thus investing too
conservatively. Over many years, the most conservative
investments (such as cash and bonds) do not keep up with
inflation. Thus ironically what seems most conservative
actually bears more risk: the loss of purchasing power to
inflation as the years pass by.
--Not accepting a loss as the sunk cost it really is. This
"sunk cost fallacy" keeps you focused on the past and
diverts attention from what you can do now to get better
results in the future.
--Selling winners too soon (to lock in profits, thus
creating a feeling of victory), but holding losers too long
(waiting for them to get back to even so that there is no
loss to regret).
--Forgetting that the real goal of investing is to build
wealth as effectively as possible, not to justify decisions
you've made in the past. This can lead you to fail to
evaluate your current investments on their potential to
produce gains from this point forward, which at any given
time is the important question to ask.
--Becoming paralyzed by too many options. This inability to
make "choice under conflict" leads to taking no action at
all when action is called for.
--Resigned acceptance of the status quo.
--Ignoring long-run "background odds" in the face of more
immediate or newsworthy information. For investors, the
important background trend is that the stock market has
returned an average of 10% to 11% since before the Great
Depression. That's more than twice as much as the bond
market.
--"Preferential bias": The difficulty in changing an
opinion about something once an opinion has been formed,
even if the opinion is only subconscious. This causes
incoming data to be processed selectively, with supportive
information being favored and contradictory information
downplayed or even ignored. The end result is reduced
objectivity.
Obviously, an investor who is subject to any or all of the
foregoing traits cannot be totally rational, even if he or
she is trying to be. The Sensible Stock Investor needs to
be as rational as possible, because over time, the stock
market tends to reward rational decisions. That is, the
market tends to move stocks towards their intrinsic values.
For example, if you paid too much for a stock, over time
the market will reduce your returns from that stock or even
turn them into actual losses as it brings the price of the
stock back to what it is really worth. Regretting the loss,
failing to accept the sunk cost, holding onto the loser too
long, failing to look ahead rather then back, and/or
resigned acceptance of the status quo obviously do not help
you make the best decision in this situation.
Fortunately, we humans can counteract some of our
psychological tendencies by using the left side of our
brain with the aid of smart tools and processes when we
are making investment decisions. Such tools and processes
would include:
• A standard system for evaluating whether a company is a
good company
• Calculating a well reasoned number as a fair price for
its stock
• Resolving never to make snap judgments on fragments of
information or hot tips
• Writing out your investment goals
• Taking into account your unique situation, including
honestly assessing your appetite for risk
• Choosing a strategy that is likely to lead to achieving
your goals without making you uncomfortable
• Making, periodically updating, and using a "shopping
list" of investments that meet your criteria; and
• Systematically reviewing your holdings with an eye to the
future.
In the end, you want to apply your intelligence and
objectivity to overcome self-defeating emotional tendencies
in your investing. Left-brain-based systems and processes
can help you to do that.
----------------------------------------------------
Dave Van Knapp is the author of "Sensible Stock Investing:
How to Pick, Value, and Manage Stocks."
Learn more about his step-by-step approach for individual
investors at http://www.SensibleStocks.com . Or go directly
to Amazon.com, where the book has a perfect 5-star reader
rating:
http://www.amazon.com/gp/product/059539342X/sr=1-1/qid=11553
81420/ref=sr_1_1/002-5852738-5260830?ie=UTF8&s=books .
Errors...Lessons from Behavioral Finance
Classic economic theory posits that investors always behave
perfectly rationally, in their own best interests. Emotions
are not involved.
You may be thinking, "That contradicts all my common
observations and experiences in life," and you would be
right. Nevertheless, classical economic theory is based on
a world full of rational, informed, iron-willed,
self-interested, consistent, and efficient actors.
Behaviorial finance, on the other hand, recognizes the
obvious: That investors are often influenced by emotion,
and that therefore they make illogical, inconsistent, and
ill-informed decisions, despite their best intentions to
act in their own self-interest.
There have been lots of studies in behavioral finance since
the field took off about 30 years ago. The studies--almost
astonishing in their variety--have attempted to find out
how most people really act when making financial decisions.
It turns out that we humans have several tendencies that
don't help very much when we are investing. They skew our
judgment. Here are the most common traits that lead to
investor self-sabotage:
--Failing to realize that the loss of an "unbooked" gain
really is a loss. Some investors only think it is a loss if
their account falls below what they originally invested.
They view an intermediate gain as not real, sort of like
playing with house money. Sorry, it was yours, and if you
didn't book it, you lost it.
--Failing to book a loss on a hopeless investment, hoping
that it will come back. This is called loss
aversion--people do not want to admit having made a
mistaken investment. Apparently, people feel more pain from
a loss than joy at an equivalent gain. They want to avoid
regret over the loss, so they just don't book it.
--Failing to take on enough risk, and thus investing too
conservatively. Over many years, the most conservative
investments (such as cash and bonds) do not keep up with
inflation. Thus ironically what seems most conservative
actually bears more risk: the loss of purchasing power to
inflation as the years pass by.
--Not accepting a loss as the sunk cost it really is. This
"sunk cost fallacy" keeps you focused on the past and
diverts attention from what you can do now to get better
results in the future.
--Selling winners too soon (to lock in profits, thus
creating a feeling of victory), but holding losers too long
(waiting for them to get back to even so that there is no
loss to regret).
--Forgetting that the real goal of investing is to build
wealth as effectively as possible, not to justify decisions
you've made in the past. This can lead you to fail to
evaluate your current investments on their potential to
produce gains from this point forward, which at any given
time is the important question to ask.
--Becoming paralyzed by too many options. This inability to
make "choice under conflict" leads to taking no action at
all when action is called for.
--Resigned acceptance of the status quo.
--Ignoring long-run "background odds" in the face of more
immediate or newsworthy information. For investors, the
important background trend is that the stock market has
returned an average of 10% to 11% since before the Great
Depression. That's more than twice as much as the bond
market.
--"Preferential bias": The difficulty in changing an
opinion about something once an opinion has been formed,
even if the opinion is only subconscious. This causes
incoming data to be processed selectively, with supportive
information being favored and contradictory information
downplayed or even ignored. The end result is reduced
objectivity.
Obviously, an investor who is subject to any or all of the
foregoing traits cannot be totally rational, even if he or
she is trying to be. The Sensible Stock Investor needs to
be as rational as possible, because over time, the stock
market tends to reward rational decisions. That is, the
market tends to move stocks towards their intrinsic values.
For example, if you paid too much for a stock, over time
the market will reduce your returns from that stock or even
turn them into actual losses as it brings the price of the
stock back to what it is really worth. Regretting the loss,
failing to accept the sunk cost, holding onto the loser too
long, failing to look ahead rather then back, and/or
resigned acceptance of the status quo obviously do not help
you make the best decision in this situation.
Fortunately, we humans can counteract some of our
psychological tendencies by using the left side of our
brain with the aid of smart tools and processes when we
are making investment decisions. Such tools and processes
would include:
• A standard system for evaluating whether a company is a
good company
• Calculating a well reasoned number as a fair price for
its stock
• Resolving never to make snap judgments on fragments of
information or hot tips
• Writing out your investment goals
• Taking into account your unique situation, including
honestly assessing your appetite for risk
• Choosing a strategy that is likely to lead to achieving
your goals without making you uncomfortable
• Making, periodically updating, and using a "shopping
list" of investments that meet your criteria; and
• Systematically reviewing your holdings with an eye to the
future.
In the end, you want to apply your intelligence and
objectivity to overcome self-defeating emotional tendencies
in your investing. Left-brain-based systems and processes
can help you to do that.
----------------------------------------------------
Dave Van Knapp is the author of "Sensible Stock Investing:
How to Pick, Value, and Manage Stocks."
Learn more about his step-by-step approach for individual
investors at http://www.SensibleStocks.com . Or go directly
to Amazon.com, where the book has a perfect 5-star reader
rating:
http://www.amazon.com/gp/product/059539342X/sr=1-1/qid=11553
81420/ref=sr_1_1/002-5852738-5260830?ie=UTF8&s=books .