We’ve all been taught that sometimes you must trust your instincts, but should you let your portfolio be guided by your intuition?
It's human nature to celebrate achievements. When we earn positive returns on our investments, we boast about them. But we never speak of our investment losses. Conventional thinking views the financial market as a collection of investors acting on rational and informed financial decisions. However, a closer look will reveal that most of those decisions are based on feelings rather than on rationality. Anyone can have an intuition about a stock, but how much can that intuition be trusted? The market is made up of millions of investors acting on their instincts, which has been hardwired into their brains.
The phenomenon of trusting our instincts to make investment decisions can be explained by concepts found in behavioral finance and evolutionary psychology. Though these fields may not be related, a great deal of behavioral finance has been found to run parallel to the ideas in evolutionary psychology. Behavioral finance studies how our minds and behavior relate to market movements, while evolutionary psychology attempts to explain much of our behavior. The human brain is wired to perform under physical risk, which it does well. Our sympathetic nervous system stimulates our stress response, which results in our “fight or flight” response. But that same brain can play tricks on you when it’s in charge of your investment instincts.
Behavioral finance studies how our minds and behavior relate to market movements, while evolutionary psychology attempts to explain much of our behavior.
Look at what happened during the dot-com bubble. The late 1990s saw excessive financial speculation driven primarily by the technology and telecommunications sector. Investors became overconfident as was evident with the excessive trading volume in the markets, specifically in the technology sector. Personal computer use was rising, telecom and technology firms were building broadband infrastructure, and the worldwide web was becoming more sophisticated. Overconfidence in the market led investors to overlook price/earnings ratios, relying instead on the promise of future technology and innovation. They invested in initial public offerings, startup companies, and other volatile markets. Lured by the promise of gains and riches, investors became so excited with the idea of becoming part of the trend that they were willing to pay almost anything.
And when technology shares started plunging, do you think investors sold out? Most likely not. There is a common tendency for investors to hold onto losing shares in the hope that they at least break even. That’s our way of not acknowledging our initial mistake of investing in them. But we also tend to sell winning stocks too soon. Although corrections are common in a bull market, our instincts kick in and we act on our fear of perceived loss. We end up selling in the trough of a bull market instead of at the peak. Suffering from these cognitive errors, we tend to buy high and sell low, which is the opposite of the adage “buy low, sell high.” The US market as a whole in 1998 was trending upward for most of the year and faced a correction of about 20% within a six-week period. This correction led many to sell too soon, resulting in missing out on the year’s overall gain of 28.6%. For them, emotion and fear kicked in, forcing them to act on irrational notions without any evidence to support those feelings.
The brain can play tricks on you when it’s in charge of your investment instincts.
The reality is our hardwired instincts tend to override logic and rationality when we confront the emotional outcomes associated with the loss or gain of an investment. But how do we stop ourselves from making the same mistakes over and over again? If we’re aware of our biases and instincts, we can begin to take a more objective view of our decisions. Because our minds don’t recognize our cognitive errors as mistakes, we must be continually conscious of what we’re doing and why we’re doing it.
A good place to start is to recognize that our mind can never tell us what the market is going to do. Once you start getting anxious about buying or selling a stock, ask yourself what kind of tricks your mind is playing on you. You don’t want your instincts controlling your trading decisions.
Source: Stocks and Commodities Magazine
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