A positive attitude is helpful in most areas of life. However, optimism should not prevail over realism in the investment arena - squelching positive emotion can lead to better returns.
Maintaining a positive attitude is helpful in most areas of life — it provides a reason to live, even when the chips are down. However, in the investment arena it can quickly drive our portfolio results south of the equator. This is because our desire for excessive investment returns can overshadow our ability to assess accurate probability. We either don’t know what is reasonable to expect or we overlook it. Optimism prevails over realism.
For example, investors fall prey to “pump-and-dump,” get-rich schemes all the time. This happens when they respond to internet solicitations from an unknown person to buy a low-cost stock that is reportedly poised to increase in value. The email sender waits until innocent victims buy the stock, pumping up its price. This is the cue for the scammer to sell and make a profit because of the artificially inflated value that he or she generated. Naïve and unwary targets are left in the lurch when the stock falls. Their hope for easy success is not only unrewarded, but it leaves them poorer.
There is at least one corollary to excessive optimism — overconfidence. This characteristic leads to losses when an exuberant investor believes he can pick stocks that are winners and, thereby, overtrades. Its deadly effects were academically demonstrated by finance professors Brad Barber and Terrance Odean, who showed that, overall, men make less in the stock market than women because men buy and sell stock more often. These researchers attributed their findings to overconfidence, characteristically found more in men than women.
A less prevalent minefield, but one that can also be associated with optimism, is excessive risk taking. These individuals are stimulating their pleasure center, the nucleus accumbens, when they make perilous financial choices. Activation in this area is associated with a positive anticipatory affective state caused by dopamine release. It makes the investor feel good.
Geneticists Kenneth Blum and David Cummings label this drive for excessive risk taking "the reward deficiency syndrome." People with this condition are unable to get adequate satisfaction from the usual rewards in life and need to up the ante.
Although the studies to date focused on addictive behavior, there may be a variation that contributes to financial risk-taking or other varieties of the same danger seeking personality such as hazardous sports. The problem for the risk-prone investor is that this behavior rarely earns better investment returns over time. Usually, it simply means that more risk is taken for the same or often less return.
As one anonymous person said, “Eagles may soar, but weasels don’t get sucked into jet engines.”
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