Believe it or not, there is a legitimate field of study which seeks to quantify the impact of emotions, psychology and behavior on investing and financial decisions – it’s called Behavioral Finance.
Behavioral Finance teaches us that just as the stock market operates in up and down cycles, markets also operate on their own “cycle of market emotions”. Interestingly these two cycles tend to move in tandem.
For example, when the market is at its peak, most investors are in a state of emotional euphoria. Then as the market trends downward toward a bottom, investors’ emotions become darker and more fearful, shifting from slight anxiety to despondency or depression.
This is the shift which can have the greatest impact on your decisions and investment results.
A Little Fun….
Take a short quiz to gauge your investor temperament.
A wager is offered where you must pick one of the following choices:
Wager (Investment) A: Gives you a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
Wager (Investment ) B: Gives you a 100% chance of gaining $500.
Which do you chose?
If you chose B then you are like most investors who are careful to avoid losses and concentrate on gains.
If you chose A, you are concentrating on the chance of winning $1,000.
Interestingly, both bets are statistically the same. Wager A has the same statistical outcome as wager B because the average gain is the same. And yet the overwhelming majority chooses Wager B.
Behavioral Finance refers to this as Loss Aversion which refers to people’s tendency to strongly prefer avoiding losses to acquiring gains. Some studies even suggest that this aversion is twice as powerful as the desire for gains.
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