Understand Your Inner Investor

Want to be a better investor? Mistrust your emotions.

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Want to be a better investor? Mistrust your emotions. As a rule, people trade more than they should, diversify less than they ought, and cling to bad decisions long after the hard evidence proves them wrong.

If this sounds like a pessimist's version of common knowledge, a growing body of research backs up humans' legacy of bad behavior. It's called behavioral finance, a mix of economics and psychology that tries to identify trends in irrational trading behavior. Meir Statman, a finance professor at Santa Clara University and an expert in the field, walked U.S. News through a few of the most common investor mistakes as seen through the lens of behavioral finance research. He also offered advice to help avoid some of the more common self-inflicted pitfalls.

You sell winners early and hold losers too long. It's called the disposition effect, a term Statman coined in 1985 along with fellow Santa Clara economist Hersh Shefrin. It explains the tendency to feel good about selling a rising stock simply because you've already notched a profit, even if the underlying logic behind buying in the first place hasn't changed. Meanwhile, that nagging sense of defeat that comes with making a bad bet keeps investors from cutting their losses. The best cure? Keep an investment history. Map out gains and losses on stocks, and follow your returns.

You (almost) never learn. So after you finally sell a laggard or watch as a sizable gain crumbles, the pain will teach you a lesson, right? Wrong. When investments turn south, people rarely take a hard look in the mirror. Research shows investors continually believe they could have predicted the best outcome if only they could go back in time and try again. It's this so-called hindsight bias that leads investors to blame bad outcomes on anything (or anyone) but themselves. "You see it everywhere," Statman says. "People just knew the crash was going to come in 2000, given what they said. They don't check how good their forecasts really are, so there's nothing to tell them that their forecasts are very bad."

You forget whom you're up against. The oft-overlooked participant in most stock transactions is the seller. Think of your average financial cable pundit. When CNBC's Jim Cramer yells "Buy!" the real question to ask is who else is listening. "People think trading is like playing tennis against a practice wall. But trading is tennis against an opponent who can be very skilled," Statman says.

Before trading, ask yourself what you know that the rest of Wall Street doesn't. If the answer is "Not much," think twice.

Overconfidence (the enemy of diversification). Unrealistic optimism, or the feeling that we're all above average, is another pitfall. Optimism is useful—realists often take fewer risks. But when it comes to investments, it can be a real danger. Optimists are more likely to hold a small number of stocks because they trust their abilities. Much as with the lottery, a few will win. But most are far more likely to lose. "They're taking greater risks than is necessary," Statman says. The solution is diversification. Go ahead and buy shares of individual stocks, but sock some cash away in that ho-hum index fund, too.

Fear rules. Getting burned on a bad trade can have long-lasting consequences. Research shows gun-shy traders beaten down by previous bad bets will wait too long to jump back into the market, essentially acting on regret. In fact, the best time to buy is when there's blood in the streets. But loss aversion—when fear of losses outweighs the desire for new gains—keeps investors on the sidelines.