Thursday, October 11, 2007

How Psychology Can Influence Your Investment Judgment

Studies have shown that human have shown patterns of irrationality, inconsistency and incompetence when arriving at decisions and choices when they are faced with uncertainty.

This field is better known as behavioral finance. This field explains how emotions influence investors and the markets. This explains why prices can go much lower or higher than the actual value when the companies faced with temporary setbacks or business opportunities. This also explains why there are market bubbles and crashes.

This is when value investing comes into picture. Warren Buffett believes in finding out the intrinsic value of a stock and buys large amount of it when the price falls below the actual value of the stock.

When a stock falls, most investors would not cut loses and withdraw his/her stocks. Instead, to avoid the pain and regret of making a bad investment, they might hold on to the stock until the stocks fall even lower until it worths nothing. An investor tends to follow the market crowd. When he sees that a lot of investors are dumping their stock in the market, they will start to fear and ignore their own judgment and start following the crowd. This could cause the stock to fall rock bottom. However, it is the value investors who profit from this who knows whether this is a permanent or temporary setback to the company stocks and whether prices will increase again.

Warren Buffett once said this Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQOnce you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Some common mental mistakes made by others 1.Believing in the majority's judgment than their own 2.Tendency to follow the crowd, believing that majority of the people cant be wrong

Some killer tips on how you can use behavioral finance to your advantage
1.Prepare a checklist and set up a system on the criteria that a company should meet before you decide to buy or sell.(e.g. How is the management? Any changes in the management? Is it a good business ?
2.Do not buy a company stock which you do not know about
3.Seek out your opinion with someone (not too many). Make sure that you are able to support your judgement on why you should buy or sell a particular stock. If you are not able to answer, then maybe this is not a good stock to invest in.
4.Keep an open mind about stock prices
5.Learn from your mistakes and do not be obsess. Always have an entry and exit strategy. When your stock shows signs that you should exit, exit immediately and cut your losses. Learn from your mistakes and move on.

Stock Market Trader

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