How our emotions hurt our investment decisions.

One of the things that differentiate investing from other financial decisions is bargain hunting.  When we buy things in stores, shop for cars or buy homes we have a tendency to look for bargains.  We may even negotiate for a lower price.  However, studies have shown that when it comes to investing, the more expensive a stock is, the higher the market rises, the more people want to buy.

It’s a common saying that the two emotions that most affect the typical investor are greed and fear.  Greed makes us buy stocks that have already gone up in price, hoping that we’re jumping on the train that is leaving the station.  Fear is what causes us to abandon the market just as it reaches the bottom.

Warren Buffett is quoted a saying: “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

The urges or biases that control our behavior have little or nothing to do with our wealth, our education or age.  Some of these biases are

• Overconfidence – we believe we know more than we really do and believe that the decisions we make are in our best interest.
• Myopia – we are overly influenced by short term results.  However short-term results are often random or dependent on “headline” events that have no long-term meaningful effect.
• Anchoring – predicting the future from the past.  For example, when we look at long term stock market returns we have tendency to project those average returns into the future, ignoring the volatility of the market over the long term.
• The cat on a hot stove effect – if a cat jumps on a hot stove, he’ll quickly jump off, but he won’t jump on a cold stove either.  after investors experience a negative event such as the losses people suffered in 2000 and 2008, they often revert to a strategy that will reduce the probability of reaching their goals by, for example, investing only in CDs or savings accounts.
• Regret aversion – not wanting to admit a mistake, investors may hold losing stocks to avoid experiencing regret over a bad decision.  Often investors will hold a losing stock for years, waiting to “get even.”

One of the biggest problems investors face today is not lack of information  but too much information.  Newspapers, magazines, TV and the Internet are bombarding the investor with information and advice: buy this, sell that, top ten funds of last year, cheapest to own, all delivered with intensity and conviction.  And many contradicting each other.

Investment advisors recognize what biases affect people and provide tremendous value to their clients by understanding and helping reduce their influence.  By education and hand-holding when greed or fear are influencing the investing public, they help their clients avoid what Warren Buffet calls their “urges” that get people into trouble.