Investors Are Too Emotional and Overconfident
May 03,2007 00:00 by admin
Investors Are Too Emotional and Overconfident
The stock market is a very difficult place to make money. This is not
a new thought. Over the past 100 years the stock market has been punctuated with sharp, uplifting bull markets, followed by swiftly
plummeting bear markets. This cycle has happened in the past, and
it will happen in the future—for after all, the markets are driven by
people. Market cycles repeat themselves, just as history repeats itself.
People are people, and where money is at stake they react emotionally,
which usually results in bad decision making. Investors have a
poor track record of making money in the market.
Numerous surveys have shown that investors buy and sell at
the wrong time, and they usually buy and sell the wrong investments
at the wrong time. Behavioral researchers have found that the
incorrect decisions which investors are prone to make are the result
of overconfidence in their investment knowledge, overtrading, lack
of diversification, and incorrect forecasting of future events based on
recent history. Stock market success requires that investors act independently
of the crowd, while using a nonemotional, time-tested,
almost mechanical investing approach. If fear and greed are not
eliminated from the investing equation, then the results can be catastrophic.
Unfortunately, investors will continue to make the same
mistakes over and over again. That is the way it is.
Robert Safian in Money magazine said: “All across America,
millions of people are afraid to open their account statements,
afraid to look at their 401(k) balances—afraid to find out what
they’ve lost during this long bear market and where they stand
today.”3 That’s a pretty sad state of affairs. But it did not have to be
that way, if investors would only have had an investment plan that
forced them to take profits as stocks kept going up, and they had
placed stop-loss orders on their stocks to protect them as prices collapsed.
But most investors froze, and did nothing until the market
was well off its highs. Then, as the market hit subsequent lows in
July and October 2002, investors took their billions of dollars out of
equity mutual funds and began investing their money in bonds and
money markets. Other investors just gave up and cashed in all their
investments, having endured severe emotional and financial pain.
The vast majority of individuals are not very savvy investors,
even though many have above-average intelligence and consider
themselves above-average investors. They do not have the time,
background, or expertise to assess the market at key turning points
(for example, whether the bull market is beginning or ending).
Moreover, the average investor’s performance is typically worse than the appropriate market benchmark or even than the actual
performance of his or her mutual funds. This outcome is a result of
poor timing on entry and exit points and lack of a coherent, wellresearched
strategy. Most investors buy and sell on a whim, or they
take advice from a friend, or they act based on hearing an “expert”
giving his opinion on the market or a particular mutual fund or
stock in the media.
All investors need a methodology to know when to buy and
when to sell, but few if any investors have even thought about it, let
alone have a methodology in place. Unfortunately, investors as a
group invest and hope for the best. This approach is no way to build
a nest egg for the future; but rather a recipe for financial disaster. You
wouldn’t leave your garden untended, since you know that weeds
would grow and kill your flowers and vegetables. The same logic
applies to your investments. Being proactive is better than being
nonactive. That is not to say that you should be an active trader or
an aggressive investor. It is saying that investing is not a static
endeavor. You should watch over your investments, making adjustments
as necessary to weed out the dead wood, and replacing them
with more fruitful pickings. You are the best gardener for your garden
of investments. Don’t let the experts tell you otherwise.
Just because you bought stock in good companies doesn’t
mean that you made a good investment. Even the so-called blue
chips have plummeted from their year 2000 highs to much lower
levels by January 2003: General Electric hit $180 ($60 split adjusted)
and went to $23; AOL Time Warner Inc. hit $95 and went to $11.50;
General Motors hit $85 and went to $36; AT&T Corp. hit $100 and
went to $19. This type of devastation doesn’t have to happen to
you, if you become a smarter investor going forward. Surely, by
heeding the advice of the Wall Street intelligentsia, you can come
out way ahead, right? Wrong! Keep reading the next section.