How good of a driver are you? Most people, when asked that question, say they are above average. An outside observer, though, would rate about one-third of drivers as below average, one-third as average, and one-third as above average. That's how it actually breaks down. But most people are overly confident in their own ability and rate themselves accordingly. (Were you one of them? I was.)
In Investment Madness, author John Nofsinger uses the above example when he discusses overconfidence, one of the many psychological pitfalls that hurt people when they invest in the stock market or otherwise handle money. The truth is, most of us are not on par with, or even in the same ballpark as, Peter Lynch or Warren Buffett. One of the reasons we don't do as well in the market is that we are too emotional.
Being emotional is not a bad thing. It just gets in the way. Overconfidence is just one pitfall in this regard. Seeking pride and avoiding regret, engaging in mental accounting, having a selective memory, and getting exuberant are some of the others. All of these pitfalls are just manifestations of our normal, emotional selves. Alas, each one can carry serious investing consequences. Nofsinger discusses each of these, among others, and gives tips on how to avoid them, or at least minimize their impact. The most successful investors already know how.
If you've ever thought about an investment, "I'll just wait until it comes back up to my purchase price and then sell it," read Chapter 5 about avoiding regret. If you've borrowed $10,000 at 8% for three years to buy a car and have $15,000 saved up for a house purchase five years from now earning 5%, read Chapter 8 about mental accounting and why this is a mistake. If you've avoided saving for retirement because of the unpleasant images that thought conjures up -- such as being old and not able to earn as much -- read Chapter 10 about cognitive dissonance -- and start saving, Fool!
Not only does Nofsinger introduce many aspects of behavioral finance in an easy-to-read manner, but he also discusses why the Internet might not be as good a thing for the average investor as we all think it is. It makes too much information available, the author argues, and it makes the ability to act on that information too easy. After all, selling Dell (Nasdaq: DELL ) when the news of its burning laptop batteries came out required no more than a mouse click or two. Discussion boards, such as those on The Motley Fool and Yahoo! (Nasdaq: YHOO ) , are mentioned as being a too-easy forum for the exchange of messages about companies. Nofsinger notes that a higher number of postings on a company's discussion board is correlated to heavier trading volume of that company's stock.
After discussing several behavioral quirks and how the Internet amplifies them to investors' detriment, Nofsinger ends the book with some ideas on how to control them, or at least minimize their impact. While some of what he writes seems obvious, such as "buy low, sell high," not enough of us actually do it, for the reasons he pointed out earlier in the book. He also provides guidelines for removing emotions from your investing decisions. While all of them might not work for everyone, the idea of recognizing emotional pitfalls and trying to overcome their effects will help make you a better investor.
My personal dragon? Like most investors, I've got many. One is that after I've made up my mind to invest in a company and see that the price is climbing, I become afraid that the price will continue to rise and I'll miss out. So I rush to buy at a higher price, only to see the price drop a short time later, down to the lower price I actually had in mind originally. While that might not be your personal weakness, I am sure that if you read this book and think about your own investing habits, you'll find an area for improvement.
Fool contributor Jim Mueller finds it easy to believe that emotions have no place in investing and more difficult to actually approach investing without them. One Fool discussion board he follows also looked at this book. He owns shares of Dell. The Motley Fool is investors writing for investors.