Investing in securities such as stocks, futures, and options is a popular activity. It is estimated, for example, that almost 50 per cent of families in the United States own stocks, either directly or through mutual funds. While some people adopt a conservative policy of buying and holding securities for long term gain, many others speculate, trading securities frequently, in the hopes of much greater gain. The availability of on-line discount investing has facilitated this process.
The activity of choosing investment vehicles involves an attempt to predict the future. In this respect, it is like much of the rest of life. We often have to take action and make choices on the basis of incomplete knowledge. Because of the often substantial amounts of money involved, investing can generate psychological stress and distress. In addition, self-esteem issues, unconscious motivations, and emotional factors can distort the decision making processes, resulting in investment failures.
Recent research by a finance professor, Dr. Terrance Odean*, at the University of California at Davis has identified a number of common investment errors resulting from psychological factors. For example, many investors are motivated by "loss aversion." For such investors, fear is a powerful motivation. The psychological pain that they anticipate feeling from a loss is far greater than the pleasure they take in making a profit of the same size. Although they have the financial means to invest, some people with this problem avoid investing altogether in order to avoid any chance of loss. For those who overcome their fear sufficiently to take the plunge, their fear tends to distort their decision processes. For example, they will hold on to a losing stock investment too long, hoping for a bounce back. Consciously or subconsciously, they feel that selling the stock will make the loss "real." Until they sell, it is only a paper loss. Alternatively, having made a paper profit on a securities investment, they will sell it too soon, for fear of losing the profit they have already made.
Many investors fear taking personal responsibility for decisions that might turn out badly. One strategy for dealing with this problem is to follow the advice of a broker or financial advisor in choosing investments. If the investments are unsuccessful, the investor can blame it on his advisor and fire the advisor. If the investments are successful, he can take credit along with the advisor. Another strategy, popular with both amateur and professional investors is to invest in "hot" stocks or mutual funds. It is easier to accept a loss on an investment that "everybody" thought was good, than on one that was not so popular.
Some professional investors or traders compound the fear of loss because they base their self-esteem upon the opinions of their peers. So, in addition to the fear of financial loss, they fear a loss of status.
The seemingly opposite side of fear is overconfidence. Unrealistically overrating one's trading abilities and prospects for success can lead to too frequent trading and bad selection of investments. Dr. Odean believes that this is so common that it artificially inflates the volatility of financial markets. One contributor to such overconfidence is selective memory. Investors want to forget their mistakes. Unfortunately, forgotten and unanalyzed past errors are likely to be repeated.
Although they appear to be opposite problems, fear of failure and overconfidence can both be manifestations of a more fundamental problem with self-esteem. One can strive to consciously identify when one has made errors based upon fear or overconfidence and resolve to behave differently. However, investors who find themselves making the same kinds of errors repeatedly may be having difficulties that would benefit from professional counseling.
*Although we make reference to Dr. Odean's valuable research in the above, the interpretations and conclusions we have drawn from his research are our own and do not necessarily represent Dr. Odean's own views. Dr. Odean's research papers are available on his web site at: http://www.gsm.ucdavis.edu/~odean.