Wednesday, December 22, 2010

Are You A Rational Investor?

Let me start by introducing to you what is Behavioural Finance. It is the study of the influence of psychology on the behaviour of investors and their subsequent effect on markets. It combined the discipline of psychology and economics to explain why and how people make irrational or illogical decisions when they make investment decisions.

For example, many investors know that before they invest in a particular stock, the first thing they should do is: RESEARCH! But honestly how many of us actually perform this step? You may be surprised that there are many investors who have the ability to do analysis on stocks but often find themselves making rush decisions based on tips and advice of their so-call expert friends. So in behavioural finance perspective, these investors are ‘irrational’.

Irrational investors are easily swayed by emotions, they do little planning, lack of savings and have low risk tolerance. Interestingly, according to statistics, there is a relationship between risk tolerance and capital base. Large capital based investors tend to have higher risk tolerance, think long term and they are more rational as compared to small capital base investors. So that means if we understand the mindset of a successful rational trader, we can actually produce the same winning strategies that have been proven for years and decades for them. All we need is to establish some ground rules for our portfolio.

Here is a summary of the six reasonable guidelines that we know work for irrational investors:

1. Never attempt to time the markets; it's impossible
2. Live below your means and save regularly
3. Asset allocation is the key to a winning portfolio
4. Buy and hold quality, and buy intending never to sell
5. Compounding guarantees long-term wealth-building
6. Do it yourself; millions do, especially millionaires

Bottom line: Nobody wants to think of themselves as an irrational investor. But the chances are four out of five that you are, and that you're probably in denial if you still believe you're rational.

Bottom line No. 2: Paradoxically, the biggest secret of the "Rational Investor" is that they know they're irrational! So they use the six rules to protect their portfolio from their own worst enemy, their brains.

Happy investing,

Pauline Yong

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