The Emotional Investor Part 2

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Image Credit: BBC.com

I wrote the first part somewhere at the start of February, and wanted to post the follow up a few days later, but somehow this matter slipped my mind. It didn’t help I got so much other stuffs occupying my thoughts and time.

Never mind, better late than never though!

Back to the topic, psychology is a vital and very important aspect of investing. Overlook it, and be prepared to under-perform. The average investors out there are driven predominantly by greed and fear. Price fluctuations are all heavily influenced by emotional investors, as they make up the bulk of the market crowd. Yes even institutional investors are prone to making emotional and irrational market moves.

Some examples of irrational and emotional behavior of investors:

1. Investors hesitate to purchase a stock when it is an obvious bargain, but instinctively chase popular stocks to very high and overpriced valuations. They either probably think that it is too good to be true or it is just too ‘unwanted’ to their liking. The hot stock seem a ’sexier’ choice.

2. Investors feel the need to take a profit on a stock that has raised a modest amount, and often missing out on much larger profits had they held on longer. Yes many of them cannot wait. They are happy to cash out on a few percentage points of gain, only to watch in horror as the price keep moving upwards.

3. Investors postpone selling stocks for a loss, even when the business fundamentals have obviously deteriorated and are rotten to the core. They rationalize that things can only look up after having sunk so low.

“It’s high time for a rebound! I will hold on just a bit longer. After all I’ve waited for so long and lost so much on paper, so no big deal holding on a for just little more!”

4. Investors become bored of holding onto a portfolio of good, solid, fundamentally sound businesses. These are companies which consistently post healthy profits, giving out decent dividends but are low on profile. However they find that there is no kick and excitement holding on to just these stocks.

They feel a strong desire to use any spare cash to trade more often just to create some activity, when they could have better spend the cash reinvesting on the good (but dull) companies that they are already holding.

Perhaps things are looking a tad too boring on paper? More activities automatically translate to more gains?

5. Both amateur and professional investors start to feel like superstars and top of the world after a few winning streaks. They begin thinking that they are the next Warren Buffett or George Soros. Or maybe even better?

“Who is this Warren Buffett? He is old-schooled! Not a threat!”

7. Acting on ‘expert investment’ advice and ‘hot tips’ from friends, financial journalists, stockbroker or even the man in the street instead of first doing his due diligence and research.

????????????????????????????? Are you guilty of such behaviors?

If you are, please prepare yourself for a rethink!

The fact is that we can profit from other people?s irrational behavior, provided we ourselves can keep our emotions in check.

Average investors like to chase the ?hottest? and ?in? stocks, pushing the price way above its intrinsic value to monstrous proportion. If we follow the crowd, we may actually end up buying when it?s at a high. That’s like a ship going on a collision course with an ice-berg!

On the other hand, certain stocks? prices fall sharply due to fearful investors going on a selling spree to cut losses, and in the process driving its price to way below its actual value. These stocks are often seen as dull and boring. Nobody wants to touch them, even if it’s offered on a silver platter.

We should be looking out for such ?dull? bargains instead, as they usually gives us a huge margin of safety. You can identify such shunned stock by its low P/E and price to book value (PBV).

To succeed, we must sometimes dare to go against the popular crowd sentiment. Go contrarian! Of course, when it comes to buying a stock nobody wants, you still have to do the proper research and scan them through proper and rigorous stock screening to ensure that it?s still fundamentally sound with good growth prospect.

Some of these companies may just be suffering a fall out from a short term over-reaction of investors. However we have to take note that some low P/E stocks are indeed really lousy! Watch out for such ?falling knifes? (term for lousy stocks which values keep dropping)! Learn to differentiate the good ones from the bad.

Adopting a contrarian approach can be quite painful, as you are not following the consensus. Other people may laugh at you for being stupid, but if you have done your homework, you will be the one having the last laugh, and all the way to the bank for that matter.

[...] and fascinating part of investment to me is standing at the sidelines to observe just how irrational investors and market as a whole can [...]