Fear And Greed
While markets are quite efficient and it is difficult to beat them over time, most casual investors seem to have a knack for being able to underperform the stock market. Most do this at least by paying too many fees. Investors put their money in mutual funds with large maintenance fees and bloated asset bases (which makes it more difficult for the mutual fund manager to invest the money). Investors also trade too much, which often costs them dearly in commissions.
But these fees aside, most investors lose money due to their emotions, specifically fear and greed. Many books have been written about how emotional thinking leads to bad investment decisions. This article will focus on the two biggest emotional culprits: fear and greed.
First, leti's talk about greed. The toxic effect greed has on investment results is rather straightforward. When a person sees others do well in an asset class or stock type, he or she decides to jump on the bandwagon and buy some too. This sort of logic has its roots in our cavemen tendencies to do something if others have done it and we deem it safe.
This cavement logic works well if we are deciding whether or not too eat a certain type of berry (if our other cavemen ate them and didn't get sick, it's probably ok to eat the berries), it doesn't work well when investing in stocks. What happens is greedy people end up buying at the top of a bubble. By the time they invest in the stock, the stock's price has ran up so much that it has become overvalued. Of course, the bubble eventually breaks and people that bought at the top lose a lot of money. Investment bubbles have occurred as soon as investment markets were formed, whether it was the Dutch tulip bubble or the tech bubble in the late 90's.
Fear is another toxic emotion for investors. It is also a much more powerful emotion than greed. Researchers have found that humans gain the same emotional satisfaction from earning 2.5 units of currency as their dissatisfaction from losing 1 unit of currency. Essentially, our caveman brain is wired so that earning $25,000 feels about as good as losing $10,000 makes us feel bad. Essentially, the emotion of fear is 2.5 times stronger than the emotion of greed, and we've already seen how greed can negatively affect our investment results!
Investors. fear causes poor investment results in two ways. First, when an investor makes a good stock investment, but for whatever reason, the stock drops significantly temporarily, the investor quickly sells the stock. Though the stock is cheap and the investor should probably be buying more, he ends up 'selling low'.
Furthermore, when stocks are cheap due to poor market conditions, most investors are too afraid to jump in. They generally wait too long and until a bubble forms to start buying stocks.
Together, fear and greed leads most investors to buy high and sell low. Don't let your emotions negatively affect your investment decisions.