The Misconception: You make rational decisions based on the future value of investments and experiences.
The Truth: Your decisions are tainted by your emotions you accumulate and the more you invest in something the harder it becomes to lose it.
History shows us that retail investors as a group get easily caught up in the emotion of investing and let fear and greed dictate their actions.
Perhaps the best example to describe this behavior is the buying frenzy that ensued during the latest stages of the tech boom when the Nasdaq soared more than 85% in 1999 alone.
Instead of paring back holdings to book profits on such an extraordinary gain, investors went on to pour another US$140-billion into stock mutual funds during the first three months of 2000. Up until then, the record for monthly net inflows of this kind was US$29-billion, but inflows hit a crazy $55.6-billion in February that year.
For now, this is becoming an issue to be worried about. People are buying stocks based on biases and headline news and not looking into the finer details.
Most people took the phrase “invest what you know” too lightly. This is because people have only superficial knowledge of companies or industries yet think they’re experts.
Even Peter Lynch, the superstar fund manager of Fidelity Magellan Fund who popularized that maxim in his best-selling book, “One up on Wall Street: How to Use What You Already Know to Make Money,” warns against misinterpreting his advice. “I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock.’”
The common wisdom of “buy what you know” leaves out the hard fundamental research on companies at which Lynch and his team excelled. People buy a stock when they know nothing about it. That’s a gamble.
Everyone loves a bull market. You can make money without much effort. But that feeling can be dangerous, because it can increase your confidence more than your ability.
If you have done great investing over the past five years, check your ego at the door. Almost everyone is making dumb bets and winning. The true test of investor skill is how you react during times of panic and distress.
It might not be for everyone, but holding some cash could help you stay calm in times of market chaos. When you can think rationally when everyone else around you is losing their heads, your portfolio may just thank you in the future.
Keep these thoughts in mind as the markets fluctuates up and down in times of uncertainty.