By BRIDGET MINTOFT
Are investors rational? Common sense suggests the answer is: not always. There are market bubbles and crashes, we try to avoid risk, we forget, we remember creatively, and we fall in love with certain stocks.
The Efficient Markets Hypothesis - accepted by many as the best explanation for
the way sharemarkets work - says these are just anomalies in an otherwise tidy and rational world. The field of "behavioural finance", on the other hand, acknowledges that investors are human and was devised as a way of explaining these so-called anomalies in rationality.
But these behaviours happen too often to be some kind of malfunction. What an economist sees as an anomaly is completely understandable to a psychologist.
The economist sees irrational investors as failures in the noble tradition of rational thought. Psychologists just see humans doing what comes naturally. Financial gain and loss aren't the only things at stake when we make decisions about money. It's far more messy and interesting than that.
Short-term self-protection, ignorance and excitement, as well as the usual biases in the way we see things, are at the root of most of the failures of judgment.
Failure to sell losing shares, called loss aversion, happens when the immediate pain of selling now, when the price is down, seems greater than the eventual pain when they are nearly worthless. But the price will come up again, right? Over-optimism is another trap.
Fear, stress or desire can alter perception of information. This is part of the reason paper trading is of limited use; these feelings are only generated with real money on the line.
Biases of thought occur fairly routinely and involve faulty judgments about our own skill, and the relative value of information. Then there are problems such as innumeracy, ignorance of probability, and money management errors.
Intellectual laziness and over-confidence can result in failure to do important homework. Paradoxically, many people overdo preparation in an attempt to avoid failure, and suffer paralysis by analysis. Trying to get useful advice from others isn't a solution either, as group process can influence rationality - try ordering a pizza for four.
Women trade less often and more profitably than men; testosterone may be hazardous to your trading. A more likely explanation is the differences in ways men and women approach the task, their degree of confidence, and risk-taking.
So the question isn't "are we rational or not?" - most of us are sufficiently rational, enough of the time, to avoid scrutiny - but rather, what factors counteract our rationality?
The answers to that question lie in all the related elements that influence perception and decision-making. These include fatigue, stress, our need for money, impulsiveness, narcissism, education, family economic history, and social pressure.
These factors give rise to many oft-quoted rules of thumb: "never trade with scared money"; "don't trade if you are tired or upset"; "don't listen to advice from family or friends".
But these rules have their limitations. Encouragement to show self-discipline, have nerves of steel or leave your ego at home are about as useful as saying "pull your socks up".
Examining these factors is complex, unglamorous and uncomfortable. Nevertheless there are some useful steps we can take.
* We need to deal with both the logical and emotional sides of trading. Neglecting one for the other can only result in loss.
* Do your homework, whatever you deem that to be.
* Realise your vulnerabilities, especially desire. If you really need the money trading may bring, you run the risk of seeing the facts in a distorted way. This often results in getting in too soon, too often, or failing to get in at all.
* Hope is a double-edged sword. It encourages us into this game, and can led to some of our biggest errors.
* Manage fear. While it brings valuable caution, it can also paralyse, and distort perception.
* Focus on the important things, not the exciting or easy things.
Preservation of capital is one of the basic rules, and yet so few take the necessary steps to do this.
Much profitable trading is dull and mechanical, and this does not appeal to many (especially novice) investors.
However, if trading is approached like the business it is, this requires a businesslike attitude.
* Bridget Mintoft is a psychologist with a completely irrational fascination for the psychology of investing.
* Procoach
By BRIDGET MINTOFT
Are investors rational? Common sense suggests the answer is: not always. There are market bubbles and crashes, we try to avoid risk, we forget, we remember creatively, and we fall in love with certain stocks.
The Efficient Markets Hypothesis - accepted by many as the best explanation for
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