In case you weren't aware, my colleague Bill Mann called you stupid not too long ago -- but it may not be your fault. According to Jason Zweig's new book, Your Money and Your Brain:
In a cruel irony that has enormous implications for financial behavior, your investing brain comes equipped with a biological mechanism that is more aroused when you anticipate a profit than when you actually get one.
That's right, we're not stupid. Rather, we're so greedy that we actually do not enjoy making money. That's a revelatory finding and one that finally explains why too many investors trade far too frequently:
We enjoy the hunt more than the rewards.
Investing is rewards, right?
That's backwards, of course. Investing, if you're doing it right, should be all about turning thousands into millions. That can be as easy as buying an index fund, or it can be done more quickly by picking individual stocks that beat the market.
The key to both of these strategies, however, is patience. If you buy an index fund and earn the market's historical 10% annual rate of return, it will take almost 50 years for $10,000 to turn into $1 million. If you do better than 10%, you can turn $10,000 into $1 million much faster -- but your time will still be measured in decades.
That's far too long for the brain. Moreover, because our minds have evolved to get more joy out of anticipation of results than satisfaction from actual results, investors are always ready and willing to chase "the next big thing."
Science explains observation
While Zweig has finally explained the brain science that backs up this conclusion (and do check out his book), academics and investors alike have observed its effects forever. For example, as money manager Ron Muhlenkamp noted, "For most people, 'The Game of the Stock Market' is a distraction that prevents them from making money in 'The Business of Investing.'"
Couple that observation with the rapid trading patterns Berkeley finance professor Terrance Odean found in his study of retail investors, and you can see why my colleague Brian Richards and I recently advised that perhaps you shouldn't sell.
See, if we're programmed to enjoy anticipating rewards more than actually receiving them, then our favorite part of investing is the transacting (hence that sense of excitement you get when you click "buy" for a new stock). While that strategy will get you a big tax and trading bill, it won't get you big returns.
Ring a bell?
If you've thought about this and decided that your portfolio is chock-full of stocks you bought in a fit of greed, perhaps it's time to start over. This week, for example, recovering mortgage and financial companies such as Freddie Mac (NYSE: FRE ) , Lehman Brothers (NYSE: LEH ) , and Thornburg Mortgage (NYSE: TMA ) have posted some fast and impressive gains thanks to recent Fed action and proclamations that "We have finally reached the bottom."
But these companies are not out of the woods. If you bought them last week and don't know exactly what their potential liabilities are, or you don't have an estimate of exactly what they're worth, it may be a sign that your greedy brain is trying to get you to chase some dead-cat bounces.
Don't fall for it
Instead, consider making a list of businesses you admire, understand, and would be confident owning for the next decade or more. (Seriously, jot them down on paper or in an electronic file.) Then, set about valuing those great companies.
It will take some time, but when you have a file full of fantastic companies with estimates of their value, you'll have a firm handle on the stocks you want to buy and at what price.
Your brain will make this difficult
Of course, while you set about making your list, you're going to worry about all of the gains you're missing out on in the market. Then, as you wait for the stocks you want to buy to hit the price you're willing to pay, you're going to want to make a move sooner. You may find yourself revising your valuations upward so you can justify buying a stock.
To combat this, consider parking the funds you've earmarked for equities in a low-cost, liquid, broad-market exchange-traded fund such as iShares MSCI EAFE, which has exposure Vodafone (NYSE: VOD ) , Nokia, Toyota Motor (NYSE: TM ) , and any other global company you'll hear hyped in the media. Then you can tell your greedy short-term brain that you're fully invested, even as you wait for better opportunities to present themselves.
Find the better opportunities
Zweig's lessons are particularly applicable to those of us who specialize in small-cap investing. Although these stocks offer big rewards, they can be excruciatingly volatile.
Subscribers to our Motley Fool Hidden Gems small-cap investing service know this well, though by training ourselves to exercise patience, we'd like to think we're able to take advantage of volatility to buy on dips and supercharge our returns.
Obviously, this works certain times better than others, but, overall, our picks are beating the market by 25 percentage points on average. You can see the stocks we're recommending today by clicking here to join Hidden Gems free for 30 days. There is no obligation to subscribe.
This article was first published Nov. 1, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. The Fool's disclosure policy would rather be stupid than greedy.