Conventional economic theory holds that people act rationally and generally do what's in their own best interests.This is a useful assumption if you want to make the numbers come out right when you're dreaming up economic theories and equations. But to anyone who has actually met a living human being, it must seem -- how to put this gently -- nutsy-bobo. 
Video: See your brain's conflict
Reviews of tens of thousands of investor accounts (with identities concealed but all the buy and sell actions revealed) have demonstrated that investors routinely make irrational choices. In the process, they frequently blow their own best interests to smithereens. Here are a few of the most common mistakes, plus some remedies:
1. I don't want to think about it right now. People tend to put off difficult decisions, especially if given too many choices. For instance, federal officials were proud to offer 60 options for the Medicare prescription sign-up last year. But in the face of so many choices, says Princeton psychologist Eldar Shafir, "people froze." Video: Why you procrastinate
Financial markets also can immobilize people because of a virtually unlimited array of stocks, bonds, mutual funds and other instruments, combined with highly uncertain outcomes. To avoid procrastination, Shafir says, try drastically reducing your investment choices. You can quickly weed out unsuitable investments by using a screening tool for stocks or mutual funds.
You should also schedule a portfolio review twice a year, just like going to the dentist. In one study of a university retirement plan, more than half of the participants reached retirement without ever changing the asset allocation they had chosen at Day One. They probably figured that the moderate-growth approach they had signed up for at 25 still suited them at 55. But in reality, they may have let immoderate risk creep into their retirement funds because they never re-balanced their portfolios to compensate for the way one asset class outperformed another.
It often takes new employees two or three years to get around to joining the company 401(k) plan, according to Harvard economist David Laibson. That may not sound so bad. But because the average worker changes jobs every six or seven years, they could end up missing half of the potential savings -- and thousands of dollars in employer matching funds -- over the course of a career. Chart: How much can you save?
2. I know something you don't know. We all like to think we can outsmart the market. Otherwise, why invest? But the truth is that even mutual fund managers, who are highly trained, full-time financial professionals, consistently underperform the market.
Overconfidence afflicts men more than women, and it leads them to trade too often. In one study, excess
trading knocked 2.65% off the annual earnings of male investors, much of it in commission costs. And here's the humiliating thing: The stocks these traders sold usually outperformed the ones they went on to buy. Overconfident investors also end up holding riskier portfolios than they should for their stated risk tolerance.
We tend to pay attention only to research that supports our points of view. So, take turns playing devil's advocate with a fellow investor. (Your devil's advocate should hold your nose to all the arguments against buying a stock now.)
If that's too big a hassle, then stop kidding yourself: Put your money in a portfolio of index funds, which mimic market performance. The ones from Vanguard typically have the lowest costs.
3. If I don't play, I can't lose. The pain we get from a loss is roughly twice as great as the pleasure we get from a win.
"A day in which you find $10 and lose $10 is a bad day," says Nick Chater, a cognitive scientist at University College London, "because $10 lost is much more unpleasant than $10 gained is pleasurable."
One possible explanation, he says, is that our income generally comes in big lumps. So a $10 gain doesn't look like much relative to your paycheck. But the $10 loss is $10 you could have spent on lunch. Video: Pain stronger than gain?
The pain of losing is one good reason not to watch your stocks every day. Even if upticks outnumber downturns, the downturns are still going to make the whole experience needlessly painful. Our exaggerated aversion to loss is also the reason we hold on to our losing stocks for way too long, waiting for them to get even again. And the pain of "losing" disposable income is why we put off saving for retirement, even though we know better.
4. I'll gladly pay you Tuesday for a hamburger today. We all know we ought to be saving for retirement, doing our homework, eating right and getting exercise. Conventional economics says that as rational people, we should act accordingly, regardless of whether the rewards come in four weeks or 40 years. And that may well be how the analytical part of the brain works. But the emotional part of the brain gets fired up by the feel-good neurotransmitter dopamine, making us discount the future in favor of what feels good today. Or as Harvard's Laibson puts it, "I'll take my cookies now and my diet next week."
As a result, we may wind up day-trading stocks that look hot -- often buying right about the time they turn to lumps of ice. We spring for loans with misleading first-year teaser rates. And we max out our credit cards
for the short-term thrill of fancy restaurants or high-price travel. OK, it's nice to give your pleasure center the occasional tickle. So set aside a small portion of your portfolio for playing the market. (It's like having a gambling pocket at the casino.) But protect your future by keeping the bulk of your money in boring long-term investments.
There. Are you feeling more rational already? Careful! That's just overconfidence back at work.
Produced by Anh Ly / Graphics by Anh Ly and Joe Farro
Return to Fear and Greed home
Published Jan. 25, 2008
High