2011-07-19 12:29:39
Sure, the economy sometimes hits a slump, whether because of a war or
unforeseen natural disaster. Of course, these things are beyond an investor's
control. But turbulence in the market can often be linked not to any
perceivable event but rather to investor psychology. A fair amount of your
portfolio losses can be traced back to your choices and the reasons for making
them, rather than unseen forces of evil that we tend to blame when things go
wrong. Here we look at some of the ways investors unwittingly inflict problems
on the market.
Following the Crowd
Humans are prone to a herd mentality, conforming to the activities and
direction of others. This is a common mistake in investing. Imagine you and a
dozen other people are caught in a theater that's on fire. The room is filled
with smoke and flames are licking the walls. The people best qualified to get
you out safely, such as the building owner or an off-duty firefighter, shy away
from taking the lead because they fear being wrong and they know the
difficulties of leading a smoke-blinded group.
Then the take-charge person steps up and everyone is happy to follow the
leader. This person is not qualified to lead you to the local 7-11, let alone
get you out of an unfamiliar burning building, so, sadly, you are more likely
to end up as ash than find your way out. This tendency to panic and depend on
the direction of others is exactly why problems arise in the stock market,
except we are often following the crowd into the burning building rather than
trying to get out. Here are two actions caused by herd mentality:
Panic Buying - This is the hot-tip syndrome, whose symptoms usually show up in
buzzwords such as "revolution", "new economy", and "paradigm shift". You see a
stock rising and you want to hop on for the ride, but you're in such a rush
that you skip your usual scrutiny of the company's records. After all, someone
must have looked at them, right? Wrong. Holding something hot can sometimes
burn your hands. The best course of action is to do your due diligence. If
something sounds too good to be true, it probably is.
Panic Selling - This is the "end of the world" syndrome. The market (or stock)
starts taking a downturn and people act like it's never happened before.
Symptoms include a lot of blaming, swearing, and despairing. Regardless of the
losses you take, you start to get out before the market wipes out what's left
of your retirement fund. The only cure for this is a level head. If you did
your due diligence, things will probably be OK, and a recovery will benefit you
nicely. Tuck your arms and legs in and hide under a desk as people trample
their way out of the market. (For more on this kind of behaviour, check out our
Behavioral Finance Tutorial.)
We Can't Control Everything
Although it is a must, due diligence cannot save you from everything. Companies
that become entangled in scandals or lie on their balance sheets can deceive
even the most seasoned and prudent investor. For the most part, these companies
are easy to spot in hindsight (Enron), but early rumors were subtle blips on
the radar screens of vigilant investors. Even when a company is honest with an
investor, a related scandal can weaken the share price. Omnimedia, for example,
took a severe beating for Martha Stewart's alleged insider activities. So bear
in mind that it is a market of risk. (For more on stock scandals, check out The
Biggest Stock Scams Of All Time.)
Holding Out for a Rare Treat
Gamblers can always tell you how many times and how much they've won, but never
how many times or how badly they've lost. This is the problem with relying on
rewards that come from luck rather than skill: you can never predict when lucky
gains will come, but when they do, it's such a treat that it erases the stress
(psychological, not financial) you've suffered.
Investors can fall prey to both the desire to have something to show for their
time and the aversion to admitting they were wrong. Thus, some investors hold
onto stock that is losing, praying for a reversal for their falling angels;
other investors, settling for limited profit, sell stock that has great
long-term potential. The more an investor loses, however, the larger the gain
must be to meet expectations.
One of the big ironies of the investing world is that most investors are risk
averse when chasing gains but become risk lovers when trying to avoid a loss
(often making things much worse). If you are shifting your non-risk capital
into high-risk investments, you're contradicting every rule of prudence to
which the stock market ascribes and asking for further problems. You can lose
money on commissions by overtrading and making even worse investments. Don't
let your pride stop you from selling your losers and keeping your winners.
Xenophobia
People with this psychological disorder have an extreme fear of foreigners or
strangers. Even though most people consider these fears irrational, investors
engage in xenophobic behavior all the time. Some of us have an inborn desire
for stability and the most seemingly stable things are those that are familiar
to us and close to home (country or state).
The important thing about investing is not familiarity but value. If you look
at a company that happens to look new or foreign but its balance sheet looks
sound, you should not eliminate the stock as a possible investment. People
constantly lament that it's hard to find a truly undervalued stock, but they
don't look around for one; furthermore, when everyone thinks domestic companies
are more stable and try to buy in, the stock market goes up to the point of
being overvalued, which ironically assures people they're making the right
choice, possibly causing a bubble. Don't take this as a commandment to quit
investing domestically; just remember to scrutinize a domestic company as
closely as you would a foreign one. (For ideas on how to get involved with
foreign stocks, check out Go International With Foreign Index Funds.)
Concluding with a Handy List
Some problems investors face are not isolated to the investing world. Let's
look at the "seven deadly sins of investing" that often lead investors to
blindly follow the herd:
Pride - This occurs when you are trying to save face by holding a bad
investment instead of realizing your losses. Admit when you are wrong, cut your
losses, and sell your losers. At the same time, admit when you are right and
keep the winners rather than trying to over-trade your way up.
Lust Lust in investing makes you chase a company for its body (stock price)
instead of its personality (fundamentals). Lust is a definite no-no and a cause
of bubbles and crazes.
Avarice This is the act of selling dependable investments and putting that
money into higher-yield, higher-risk investments. This is a good way to lose
your shirt--the world is cold enough without having to face it naked.
Wrath This is something that always happens after a loss. You blame the
companies, brokerages, brokers, advisors, the CNBC news staff, the paperboy -
everyone but yourself and all because you didn't do your due diligence. Instead
of losing your cool, realize that you now know what you have to do next time.
Gluttony A complete lack of self-control or balance, gluttony causes you to
put all your eggs in one basket, possibly an over-hyped basket that doesn't
deserve your eggs (Enron, anyone?). Remember balance and diversification are
essential to a portfolio. Too much of anything is exactly that: TOO MUCH!
Sloth You guessed it, this means being lazy and not doing your due diligence.
On the flip side, a little sloth can be OK as long as it's in the context of
portfolio activity. Passive investors can profit with less effort and risk than
over-active investors.
Envy Coveting the portfolios of successful investors and resenting them for
it can eat you up. Rather than cursing successful investors, why not try to
learn from them? There are worse people to emulate than Warren Buffett. Try
reading a book or two: knowledge rarely harms the holder.
Conclusion
Humans are prone to herd mentality, but if you can recognize what the herd is
doing and examine it rationally, you will be less likely to follow the stampede
when it's headed in an unprofitable direction. (For related reading, see The
Madness Of Crowds.)
by Andrew Beattie
Andrew Beattie is a managing editor and contributor at Investopedia.com. He
operates the Wandering Wordsmith blog, and can be reached there.