Forget the herd mentality

Emotions play a significant role when making investment decisions, either causing people to fear losing money, buy in a "hot" stock or feel buyer’s remorse. Acting without emotion is extremely difficult when making investment decisions.

An ongoing study of behavioural finance has uncovered common characteristics among investors, including the following:

• Herd Mentality.

Investors figure if everyone is buying a particular stock, it’s got to be a good, safe investment. But, by going with the flow, investors do not take the time to adequately research a particular investment. Therefore, they are not making an informed decision. People do not want to regret making a bad decision, but herd mentality allows them the comfort of knowing they aren’t alone in their decision.

• Overconfidence.

Investors tend to be overconfident or self-assured in their abilities. According to John Nofsinger, author of The Psychology of Investing, overconfidence stems from two things:

• Illusion of knowledge: gathering a lot of information leads investors to believe their forecasts are more accurate, and

• Illusion of control: believing they can influence the outcome of events based on past investing successes. Overconfidence can influence investors to trade too frequently and hold onto riskier investments too long.

• First Impressions.

People equate investing with their first investing experience. If they choose a winning investment the first time they invest, they perceive investing as less risky. Investors tend to use past investment outcomes to evaluate a current situation. Perhaps this is the reason for the disclaimer: "Past performance is not indicative of future results. Your investments may earn more or less."

• Risk Aversion.

Investors will choose a sure thing over another choice that has a potentially higher return, but involves more risk. People are generally risk-averse and seek actions that cause pride and avoid actions that create regret. Pride is the pleasure investors experience when investments perform well. Regret is the pain investors feel when investments perform poorly and they second-guess their decisions. The feelings of pride and regret will cause investors to sell good investments too soon and hold on to bad investments too long. When this happens, investors will pay more capital gains taxes and earn a lower return.

• Out of Context.

People react to information based on how it is received, and will only see the "frame of reference" rather than the big picture.