May 25, 2010
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When it comes to investing, our worst enemy may be the one we see in the mirror every morning – ourselves.
Our impulses prompt us to run from danger and chase success, to sell our investments when all seems lost and buy when the future looks bright. We are prone to behavioral biases that can distort our decision-making. Left unchecked, our emotions and biases can wreak havoc on our financial well-being.
Unfortunately, mere awareness of these tendencies is not enough to keep them in check. Our emotions and behavioral biases are a part of us, and while some people are certainly more susceptible than others, these influences affect all of us to some degree. Awareness can, however, teach us to identify the situations in which we are most vulnerable and plan accordingly.
The beast within
Greed and fear are both alive and well on Wall Street today, as they have been throughout history. These emotions drive market prices much lower than seems justified during times of despair and push prices well beyond any realistic measure of fair value during times of plenty. That these patterns of overreaction are so regularly repeated, that we seem incapable of learning from history, is an indication of the power of these emotional forces.
The fact is, we are not well equipped to deal with the daily ups and downs of the marketplace. Most economic theory is built on the assumption that actors behave rationally, and most people would prefer to think of themselves in that way. Unfortunately, the evidence says otherwise. What behavioral finance has to say about our tendencies as investors is frightening.
Far from the rational man of classic economics, studies suggest that when faced with complex economic decisions, people often resort to general rules of thumb and other shortcuts. Furthermore, when we are faced with high uncertainty and anxiety, our emotions and instincts take over. This is particularly true when money – the prospect of making it or losing it – is involved.
During times of severe market turmoil and mounting investment losses, our emotions and their instinctive pull grow ever stronger. In a crisis scenario, the emotion is fear – the impulse is to run away from danger. When markets are rallying and all seems right with the world, greed begins to take hold. Bull markets make all participants look like geniuses – an illusion that always proves temporary – and everyone wants their share.
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