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PsychologyofInvesting - Commentary_44_8 3:31 PM Page 1...

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D OUBT McRae Capital Management, Inc. Investment Counsel Number 44 October 2004 Over here we have a very nice stock. It seems to fit you— conservative, but not dated. Now, over here we have something much edgier—very tech, so ‘tomorrow looking.’ In the funds department, I can show you several designers’ collections. They’re getting rave reviews from the financial press.” No, you don’t go to a department store to invest. Not yet, anyway. But it’s no coincidence that the investment community refers to individual clients as their “retail business.” W e all know that emotion plays a major role in individuals’ decision-making. When was the last time you chose an automobile strictly on rational factors, such as a line-by-line comparison of three or four comparably priced models? From the biggest purchase decisions—like a home—to ordinary ones—like buying a sweater—emotional feelings and preferences tend to have the last word. The rational mind may say, “I need a new coat.” The more subjective emotional side will proba- bly exercise the final decision as to which coat you buy— as in “I want that coat.” Marketers have studied the consumer’s buying habits ad infinitum . Substantially less study has been given to the emotional/psychological side of investing. Most of it is strictly superficial, as in the old dictum about investors being driven by fear and greed. That’s too bad because emotions are every bit as important as rational thinking, especially for individual investors. That may be changing, however—even for the pros. In recent years, a school of thought called behavioral finance has sprung up to focus on the ways in which emotions affect professional investors’ supposedly rational decision-making. If professionals can fall victim to the whim and caprice of emotion, individual investors are at significantly greater risk. For most individuals, emotion dominates rationality.
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