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Dumb, dumber, dumbest
By Robin Bowerman
Smart Investing
18th September 2009
Principal & Head of Retail, Vanguard Investments Australia

One of Smart Investing's more favoured topics is to warn investors about the dangers of letting emotions enter their investment decisions.

As specialists in behavioural finance tell us: there is no place for emotion when making sound investment decisions.

Forbes Magazine journalist Scott Woolley picks up this theme in a recent feature, Emotional Investors' Seven Dumbest Mistakes.

"Daniel Kahneman won the the Nobel Prize in economics seven years ago for his work on how irrational humans systematically make mistakes," Woolley writes. "Since then, research in that field has exploded."

And not only has the amount of research significantly increased, but the global financial crisis has surely given researchers much more to work with given the level of irrational behaviour among unnerved investors.

Woolley interviewed financial planner Amy Barrett from Savant Capital Management in the US about emotionally-driven investors who "anchored" themselves to the sharemarket trough by moving into cash when prices were at a low. But those investors were now having trouble convincing themselves about when to reenter the market.

With the assistance specialists in investment and investor behaviour, Woolley then discusses what he labels as the "seven dumbest mistakes" caused by personal investors' emotions. Here are just three of them:

  • Anchoring: As discussed, this involves selling out of shares after the market has fallen and then having difficulty about deciding when to reenter for fear of paying too much – instead of making an objective and logical investment decision. "Anchoring" is an excellent word to sum up just one of the pitfalls of trying to time the market.
  • Overconfidence: In this context, it is a belief by some investors that they somehow have the ability to "outwit and thus outperform the market" without having a basis for such confidence. Overconfidence plays tricks on investors in rising and falling markets. 
  • Mad investments: This refers to investors making knee-jerk investment decisions when angry about how the markets have gone or perhaps about some investment advice. "When I get angry, I'm going to walk away for an hour [before making an investment decision]," says Dan Ariely, professor for behavioural economics at the Massachusetts Institute of Technology.

Some investors may be tempted to dismiss these tips as "simply commonsense". But in a way, that's the point. When emotional investment decisions are made, commonsense is usually forgotten.