Following the crowd

Some researchers theorie that investors follow the crowd and conventional wisdom to avoid feeling regret if their decisions prove to be incorrect. Many investors find it easier to console themselves on a loss from a popular stock since everyone else owned it and thought highly of it.

Buying a stock with a poor image is harder to rationalize if it goes down. Additionally, many believe that money managers favor well-known companies because they are less likely to be fired if they under-perform.

This could explain why stocks with low price-to-book ratios or down-trodden stocks have consistently outperformed the 'glamour stocks', and by a wide margin at that.

Linear extrapolation People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when

the market goes up and more pessimistic when the market goes down.

As an example, Prof Shiller found that at the peak of the Japanese market, 14 per cent of Japanese investors expected a crash, but after it did crash, 32 per cent expected a crash. Many believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.

Over-confidence People are also generally over-confident about their own abilities, and investors and analysts are particularly over-confident in areas where they have some knowledge. However, greater confidence frequently doesn't correlate with greater success.

For instance, studies show that men consistently over-estimate their owe abilities in many areas including athletic skills, leadership and ability to get along with others. Money managers, advisers, and investors are consistently over-confident in their ability to outperform the market. However, most fail to do so.

Analysts get the impression that they are in a good position to forecast the earnings of a company after having visited it. A recent study by Chan, Karceski and Lakonishok, however, concluded that 'over long horizons, however, there is little forecastability in earnings, and analysts' estimates tend to be overly optimistic'.

All in all, they said, evidence suggests that the odds of an investor successfully uncovering the next stellar growth stock are about the same as correctly calling coin tosses. On the whole, the absence of predictability in growth fits in with the economic intuition that competitive pressures ultimately work to correct excessively high or excessively low profitability growth, they concluded.

More than just monetary gains

Many researchers theorise that the tendency to gamble and assume risks is a basic human trait. Entertainment and ego appear to be some of the motivations for peoples tendency to speculate. This would explain why many are willing to act on market gossip, which often turns out to be just noise.

People also tend to remember their successes, but not their failures, thereby unjustifiably increasing their confidence.

Arnold S Wood, president and CEO of Martingale Asset Management, noted that one risk in the investment world which is often overlooked is behavioral risk. He contends that flaws in behavior in the investment arena are prevalent, dependable and exploitable.

'Investors may recognize such flaws, but cognitive dissonance often prevents overcoming them. Once minds are set, disconfirming evidence is resisted with gusto, he wrote. As the 1950s cartoon raccoon Pogo summarized: We have met the enemy, and he is us."