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Special Section Investmental illness: A guide to getting well

If markets are rational, they sure are composed of a lot of irrational people who are driven by fear and greed.

Investmental illness: A guide to getting well

Investing, in theory, is very simple: Buy low and sell high. That means you must sell when others are buying and buy when others are selling. But even simple things can be extremely difficult to do.

Think back to 1999. Imagine that you'd made a lot of money over the past couple of years in tech and Internet stocks. Your friends profited handsomely, too. Positive reinforcement was everywhere. Every time you picked up an investment magazine or flipped on CNBC, financial analysts Henry Blodget and Mary Meeker were touting the very same stocks that you'd discussed with your friends -- and validating your investment decision not to sell. Even to buy more.

If you had expressed skepticism -- or worse, mentioned selling -- you would have had to overcome a good deal of negative reinforcement. Your friends would have pooh-poohed your pessimism. "Doom and gloom!" they would have chanted.

The thing is, you would have been right.

This is the world of investor psychology -- where "investmental health" is a topsy-turvy, Alice-in-Wonderland inversion of popular sentiment. The superior investor must be willing to appear crazy, risking ostracism by his or her friends. And the sanest among us will -- at market tops and bottoms -- appear out of touch, stupid or just plain nuts.

The discipline
At the nexus of psychology and investing lies an obscure academic field known as "behavioral finance." Behavioral patterns of theoretical "rational" investors are well-understood. And much economic theory is predicated on the assumption that markets are rational. But if markets are rational, they are made up of a lot of irrational people! Behavioral financiers try to answer this question: What happens when financial theory intersects with flawed human beings who are motivated not by pure rationality, but by personal and brand-name loyalties and the twin engines of fear and greed?

Behavioral finance experts have studied the problem and have found that, far from being rational, investors in the real world are often wracked by extreme emotional disturbances. Most mental maladies fall into two broad categories: narcissistic delusions and loss-avoidance disorders. These conditions afflict investors just like us. But we can do things to inoculate ourselves against them.

-- Posted: July 31, 2006
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