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Fear vs. Greed: Increase your Gains and Minimize your Losses
Don't Let the Red Numbers Get You Down
After watching the Dow plummet to the point of no return, and seeing portfolio returns diminish, one’s first instincts are to dump their stocks and put whatever cash is left into a savings account. These feelings are perfectly normal. No sane person wants to give up their money to Wall Street, but we must learn not to let our feelings and emotions distract us from making intelligent investment decisions.
Ever wonder how a company can have excellent financials and still underperform? It’s due in part to behavioral finance, which is basically the psychology behind investing that involves the individual feelings and emotions of investors. These feelings can be based on false perceptions, which lead to irrational market occurrences and inaccurate stock prices. Suppose someone has a billion dollars to invest in a single stock, and their broker suggests a poorly rated company simply because he or she will make a fortune on commission. Now the number of shares available has been decreased and the price per share has increased, making the company appear more attractive than it really is. This example may be extreme, but it does occur frequently on a smaller scale. People often follow their broker’s intuition, which may be biased on their own positive or negative feelings toward an investment.
If Every Investor Jumped Off of a Bridge…
Typically, there is an overall sentiment toward the market in general, shared by an aggregate of investors. This massive group, that is a component of the investing public, often has the same expectations of the market, thus causing it to fluctuate up and down. Last year, when the market began to slip, everyone jumped on the selling bandwagon and drove down stock prices as well as individuals’ portfolio values. Who can blame them? It was basically a massive game of “hot potato” and the last person holding the potato (or in this case, stocks) got burned the worst.
It’s never good to be the last one holding a particular investment, because theoretically the value would be approaching zero as more people exited their positions. However, it is good to be the first person to buy in. Microsoft is proof that it pays to get in early, literally. The first people to get their hands on Microsoft stock in the 80’s are now rich beyond their wildest dreams. So as far as behavioral finance is concerned, the best advice one could give is simply: Don’t follow your instincts!
Every Day is Opposite Day in the Market
Everyone around may be in a buying or selling frenzy and it may be tempting to follow the masses, but think about this. In any transaction, there is a buyer and a seller. When stocks were all being sold like hot cakes last year, who was on the buying side? (One man’s trash is another man’s treasure, of course.) Obviously, the stocks sold couldn’t be without the potential for returns, or else no one would buy them. Who wants to invest in something with no profit potential? It seems that an investor is more successful when he follows his own path and chooses his own companies, rather than buying and selling with everyone else. If stocks are bought while the market is soaring, there is less room for gain and more room for loss. The same is true for down swings. The intelligent investor that is making high returns today is the investor that buys when everyone sells and sells when everyone is buying. This investor saw the downturn in the market as a rare opportunity, rather than a financial disaster.
My point is that you should do the opposite of what the rest of the investing public is doing. Follow logic over emotions to prevent actions such as buying high and selling low. Greed and fear may drive the market, but don’t let them drive you!