So why do absolutely overvalued and overrated stocks go up and up when cheap high quality stocks often come to a standstill?
In the stock trading game, by and large, the brain is being switched off and the logical thinking stops - which can be risky and may cost a lot of money.
It is the same repeatedly. When a stock makes a lot of profit investors often fall in love with a stock. But when it drops, many of us just look at the not so good news and just have a tendency to see dark clouds on the horizon and act appropriately by selling as opposed to sizing up the fundamental data and the perspective of somebody from the corporation.
They are getting directed by emotions i.e. psychology. Where appropriate action is necessary, hunches and gut feelings take control instead of turning the brain back on.
Science and research has looked at what is called “Behavioral Finance” to find solutions to why and how traders arrive at such reasonless behavior. They try to find out what makes investors “tick” and why many of them toss their money at risky securities like OTC (over the counter) stocks.
Rational thinking was also hugely forgotten during the late 90’s and greed took over. Many beginners to the stock market observed how the markets where skyrocketing and so they purchased virtually any stock that promised to rise without thinking and taking even the slightest fundamentals into consideration. It had been almost uncontrollable to purchase stock.
While, during the boom of the 90’s, the majority of us rushed and charged at what I call scrap stocks - regardless of how expensive they were - nobody was enthusiastic about the cheaper but good quality stocks which were readily available for give away prices during the 3 year resession that followed.
This really is completely illogical. No one was interested in the best stocks around which were out there at discount prices because many of them had fallen 70, 80 and even 90%.
For thousands of years investors have made the same mistakes over and over again. They're being led by feelings. Many of them sell stocks that have been doing well far too soon - thrilled to have made a profit that they don’t wish to lose anymore.
In contrast, the same investors keep losing positions way too long. They really don't like selling at a loss since this means owning up to the truth that their investment decision was a mistake. And who enjoys making mistakes?
Yet this is just about the most very important lessons traders should understand: It is only worth while holding on to stocks, that have dropped, which are of top quality and where the probability of a turnaround is more probable than not at all.
Behavioral finance research also identified that a majority of traders already make their first goof ups during their research when they start to look for information regarding their future investments.
When they expect a stock to move up they overrate good news more than bad. And by the same token, whenever they expect a stock to fall, they over weight bad news a lot more than the good news.
Economic authorities like Warren Buffett or Andre Kostolany have always asserted that, on short-term, only 10% of what is said and thought in the financial markets is based on fact. Everything else is psychology which leads to the very same mistakes over and over since most traders, especially the private ones, have no method and therefore are very vulnerable to any or all the background noise and nonsense that is put on them.
If you'd like to be a successful investor it is important to power down your hunches and gut feelings, not your head. And you've got to develop a method.
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