Market Problems? Blame Investors

Sure, the economy sometimes hits a slump, whether because of a war or unforeseen natural disaster. Of course, these things are beyond an investor's control. But turbulence in the market can often be linked not to any perceivable event but rather to investor psychology. A fair amount of your portfolio losses can be traced back to your choices and the reasons for making them, rather than unseen forces of evil that we tend to blame when things go wrong. Here we look at some of the ways investors unwittingly inflict problems on the market.

Humans are prone to a herd mentality, conforming to the activities and direction of others. This is a common mistake in investing. Imagine you and a dozen other people are caught in a theater that's on fire. The room is filling with smoke and flames are licking the walls. The people best qualified to get you out safely, such as the building owner or an off-duty firefighter, shy away from taking the lead because they fear being wrong and they know the difficulties of leading a smoke-blinded group.

Then the take-charge person steps up and everyone is happy to follow the leader. This person is not qualified to lead you out of the nearest 7-Eleven let alone get you out of an unfamiliar building on fire, so, sadly, you are more likely to end up as ash than find your way out. This tendency to panic and depend on the direction of others is exactly why problems arise in the stock market, except we are often following the crowd into the burning building rather than trying to get out. Here are two actions caused by herd mentality:

• Panic Buying: This is the hot-tip syndrome, whose symptoms usually show up in buzzwords such as "revolution," "new economy," and "paradigm shift." You see a stock rising and you want to hop on for the ride, but you're in such a rush that you skip your usual scrutiny of the company's records. After all, someone must have looked at them, right? Wrong. Holding something hot can sometimes burn your hands. The best course of action is to do your due diligence. If something sounds too good to be true, it probably is.
• Panic Selling: This is the "end of the world" syndrome. The market (or stock) starts taking a downturn and people act like it's never happened before. Symptoms include a lot of blaming, swearing and despairing. Regardless of the losses you take, you start to get out before the market wipes out what's left of your retirement fund. The only cure for this is a level head. If you did your due diligence, things will probably be OK, and a recovery will benefit you nicely. Tuck your arms and legs in and hide under a desk as people trample their way out of the market. (See also: Behavioral Finance Tutorial.)

Although it is a must, due diligence cannot save you from everything. Companies that become entangled in scandals or lie on their balance sheets can deceive even the most seasoned and prudent investor. For the most part, these companies are easy to spot in hindsight (e.g., Enron), but early rumors were subtle blips on the radar screens of vigilant investors. Even when a company is honest with an investor, a related scandal can weaken the share price. Martha Stewart Living Omnimedia, for example, took a severe beating due to its namesake's alleged insider selling. So bear in mind that it is a market of risk. (See also: The Biggest Stock Scams of All Time.)

Gamblers can always tell you how many times and how much they've won, but never how many times or how badly they've lost. This is the problem with relying on rewards that come from luck rather than skill: You can never predict when lucky gains will come, but when they do, it's such a treat that it erases the stress (psychological, not financial) you've suffered.

Investors can fall prey to both the desire to have something to show for their time and the aversion to admitting they were wrong. Thus, some investors hold onto stock that is losing, praying for a reversal for their falling angels; other investors, settling for limited profit, sell stock that has great long-term potential. The more an investor loses, however, the larger the gain must be to meet expectations.

One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss (often making things much worse). If you are shifting your non-risk capital into high-risk investments, you're contradicting every rule of prudence to which the stock market ascribes and asking for further problems. You can lose money on commissions by overtrading and making even worse investments. Don't let your pride stop you from selling your losers and keeping your winners.

People with this psychological disorder have an extreme fear of foreigners or strangers. Even though most people consider these fears irrational, investors engage in xenophobic behavior all the time. Some of us have an inborn desire for stability and the most seemingly stable things are those that are familiar to us and close to home (country or state).

The important thing about investing is not familiarity but value. If you look at a company that happens to look new or foreign but its balance sheet looks sound, you should not eliminate the stock as a possible investment. People constantly lament that it's hard to find a truly undervalued stock, but they don't look around for one; furthermore, when everyone thinks domestic companies are more stable and try to buy in, the stock market goes up to the point of being overvalued, which ironically assures people they're making the right choice, possibly causing a bubble. Don't take this as a commandment to quit investing domestically; just remember to scrutinize a domestic company as closely as you would a foreign one. (See also: Go International With Foreign Index Funds.)

Some problems investors face are not isolated to the investing world. Let's look at the "seven deadly sins of investing" that often lead investors to blindly follow the herd:

1. Pride: This occurs when you are trying to save face by holding a bad investment instead of realizing your losses. Admit when you are wrong, cut your losses and sell your losers. At the same time, admit when you are right and keep the winners rather than trying to overtrade your way up.
2. Lust: Lust in investing makes you chase a company for its body (stock price) instead of its personality (fundamentals). Lust is a definite no-no and a cause of bubbles and crazes.
3. Avarice: This is the act of selling dependable investments and putting that money into higher-yield, higher-risk investments. This is a good way to lose your shirt—the world is cold enough without having to face it naked.
4. Wrath: This is something that always happens after a loss. You blame the companies, brokerages, brokers, advisors, CNBC, the paperboy—everyone but yourself and all because you didn't do your due diligence. Instead of losing your cool, realize that you now know what you have to do next time.
5. Gluttony: A complete lack of self-control or balance, gluttony causes you to put all your eggs in one basket, possibly an overhyped basket that doesn't deserve your eggs (Enron, anyone?). Remember balance and diversification are essential to a portfolio. Too much of anything is exactly that: TOO MUCH!

Humans are prone to herd mentality, but if you can recognize what the herd is doing and examine it rationally, you will be less likely to follow the stampede when it's headed in an unprofitable direction. (See also: The Madness of Crowds.)