THE INVESTOR PSYCHOLOGY QUIZ
Emotion, not logic, usually rules our investing habits. In many ways, we're predisposed, not just to buy high and sell low, but to cling to losing investments we should sell, ignore threats to our wealth, and follow the investing herd off a cliff again and again.
To help you make better investing choices, here are 8 questions plumbing insights from behavioral psychologists. See how you can avoid becoming your own worst enemy:
Question 1 of 8
We think something is safe because everyone is doing it. This is called...
A. Peer pressure
B. Herd behavior
C. Mental inertia
The right answer is B. Herd behavior.
When markets rise, investors pile in. Then as portfolios swell, we start to feel a collective buzz courtesy of dopamine, a feel-good chemical that the brain produces at the mere thought of making money. The more dopamine is produced, the more primitive our decision-making becomes, making it harder to think logically.
Question 2 of 8
Which emotion do behavioral experts think drives people into rising markets when they see others making money?
The right answer is C. Regret.
Sure, excitement, envy, and optimism about making a killing may be factors. But it's the powerful emotion of regret for not having enjoyed the ride up, that causes those who can't stand being left out to jump in.
Question 3 of 8
Why do you see your investment as less risky when its value has been going up steadily?
A. Risk tolerance--you learn to handle risk.
B. Greed, plain and simple.
C. What's most recent in your mind is what stands out.
The right answer is C. What's most recent in your mind is what stands out..
It's called the Recency Effect, and it's what affected investors during the real estate and market run ups from 2003 to 2006. Smart people lost their sense of caution because they had known nothing but gains for several years. When investments go up, we start seeing them as less risky. So we look around for riskier investments. Big mistake.
Question 4 of 8
Human minds are hard-wired to organize facts around...
B. Love songs
C. Power Point presentations
The right answer is D. Stories.
Consider the fable of the Internet Bubble. There was a time 10 years ago when serious people believed the Web would lead to an unending explosion of commerce. Similarly, stories of people getting rich as property prices rose year after year inspired many more to move fast to get rich themselves--living happily ever after? They ignored mounting evidence of “bubbles” building in the real estate market. And like all bubbles, these popped.
Question 5 of 8
Speculative homebuyers in Las Vegas and Phoenix made a key mental mistake earlier this decade. What was it?
A. They bought too high and were too late to cash in.
B. They ignored obvious but important facts, such as the virtually infinite supply of land around both cities.
C. They listened to their inner demons. Now they must pay the price.
D. Mistake? What mistake?
The right answer is B. They ignored obvious but important facts, such as the virtually infinite supply of land around both cities..
Ignoring facts that puncture a “too-good-to-be-true” story is known as confirmation bias—we only look for things that support what we want to believe. In the case of real estate prices in Las Vegas and Phoenix that rose at double-digit rates, there were many warning signs that the increases couldn’t continue. One is that both cities are surrounded by hundreds of miles of vacant land, yet people saw real estate as a scarce commodity.
Question 6 of 8
When we lose money, our brain reacts in the same way that it processes…
The right answer is C. Pain.
Losing money hurts. For many people, plunging portfolio values during the Panic of 2008 and the savage bear market of last winter became too much to bear. They just wanted the pain to end. So they sold. The timing couldn’t have been worse. As it turned out, stocks bottomed on March 9, 2009 and have surged more than 50% since then.
Question 7 of 8
What’s a smarter strategy than running with the herd?
A. Be a loner.
B. Stay out of the market until the direction is clear.
C. Don’t ever change or rebalance your portfolio.
D. Put all your money in one fund with a manager you like.
The right answer is A. Be a loner.
Think for yourself, using strategies to separate from the herd. So for example, if the U.S. government continues to run up massive deficits, you might be wise to move at least 20% to 40% of your assets out of the U.S., recommends one loner, Bob Rodriguez of First Pacific Advisors. Or perhaps follow the advice of another loner, Warren Buffett: Do your homework, select a portfolio of promising equities, and then hold on for 10 years.
Question 8 of 8
OK, so you recognize yourself in some of the miscues we’ve just described. How can you change your investing strategy to neutralize negative impulses?
A. Open a “safe money” account with low-risk investments that you think will hold up even during another stock-market crash.
B. Diversify your portfolio
C. Practice dollar-cost averaging.
D. Hire a good adviser to help you avoid bad impulses.
E. All of the above.
The right answer is E. All of the above..
What is dollar-cost averaging? By investing a fixed amount of money on a regular basis, which is how most employees contribute to their retirement plan, you avoid the temptation to buy high, or to pull out if the market tumbles.
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