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It seems to happen every fall. The stock market is rolling right along, hitting new highs every week or so. And then by September or October something spooks the markets.
Investors who have been ignoring economic warning signs all year suddenly start paying attention. Sometimes when the S&P 500 drops by 5% or so, they make a snap judgment to sell, ignoring the double-digit gains it’s posted so far.
They rely on CNBC to guide their next move. They spend every waking minute agonizing over whether to hang on or bail out.
Millions of people invest this way, on impulse. They worry whenever there is any sign of market turbulence and give in to their fears and then get burned.
We’ve all seen this movie and know how it ends. And who benefits the most? The huge institutional traders on Wall Street.
They profit by capitalizing on the impulsive behavior of Main Street investors. Motivated by the twin fears of “I can’t afford to lose” and “I don’t want to lose out,” these investors routinely buy high and sell low.
And Wall Street cashes in by selling high and buying low. Time after time, year after year.
The inevitable results of these David vs. Goliath trading interactions are so predictable that Wall Street has a euphemism for it: exploiting market inefficiencies. The big traders can predict with razor-sharp precision when regular investors will give in to their fears or greed.
Their analysts get access to the information they need to buy or sell shares of stock at the best price long before this same information percolates down to regular investors.
Here is how to understand and avoid self-defeating behavior.
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Emotions are the enemy of investing. When you’re plagued by doubt, you’re more likely to embrace certain thought patterns or superstitions that result in bad decisions. When you’re emotionally biased, you’re less willing to listen to views that could keep you from going down with the ship.
Psychologists have developed a whole field of study to identify these kinds of self-defeating thought processes: behavioral finance.
Numerous studies have shown that anxious investors often see and react to trading patterns that don’t really exist. They develop biases that aren’t easily shaken. And they fail to see the financial forest for the trees.
While hundreds of these behaviors have been researched and catalogued, there are a few that even the most experienced investors will recognize as applying to themselves at one time or another.