Psychology is a subject an investor should pay rapt attention and not take lightly. The market is made of people’s desire to buy or sell depending on the day of the week. Since human emotions affect buy/sell decisions, it’s logical to conclude that psychology plays a huge role in the stock market. Here are some examples of human behavior in the markets that may not seem rational.
Use of leverage at the wrong time. When dealing with money, people at one point or another experience the two extremes of greed or fear. When markets are running hot (only going up), everyone is comfortable with borrowing on margin, trading derivatives, all resulting in more leverage. This newfound leverage translates to portfolio risk, which makes your portfolio more vunerable to stock market fluctuations.
Chasing winners is something everyone loves doing. There is more comfort in holding a winner than a loser. The rationale behind this urge to buy winners is that it can continue moving up and has the possibility of quick returns and “easy” money This was the logic behind the dot com bubble, stocks seemed to only move in one direction and you couldn’t go wrong holding Yahoo or Cisco because everyone else held it. As my dentist told me back during the late 1990s, “it was very exciting to watch Cisco go up everyday until it stopped going up”.
Holding on to losers, everyone who has held a stock that has dropped more than one wanted it to. So we hope and pray and wait for it to turn around. It’s only a matter of time right? There are a few cases where stocks do rebound back to prices where it use to trade however that usually doesn’t turn out to be the case. For example, during the dot com bubble, technology companies traded with extremely high valuations. Speculators were willing to overlook these valuations because these internet companies were experiencing explosive growth and could potentially earn billions in the process.
Going back to the topic of holding on to losers, if you bought Cisco at 100-200 times earnings back in the heyday, it’ll be quite some time before you’ll be able to recoup your investment back.
This topic will be addressed with further examples in a later post.
