The Irrational Investor

For decades, economists have speculated, theorized and argued about the "rational actor"—a completely logical creature who always makes the sensible financial choice. Now psychologists are weighing in, and they're finding that real people often don't act that way. "Psychology has a story to tell about investing, and it's different from the one economics tells," says Princeton psychologist Daniel Kahneman.

Average investors are full of irrationalities and inconsistencies, according to the field of study known as behavioral finance. Some of their characteristics:

• Too self-confident. Investors often ignore the role of chance, preferring to preserve an illusion of control by exaggerating both their own skill and the importance of that skill.
• Too bold. Professional and amateur investors alike tend to have an "optimistic bias," believing that their chances are better than the next guy's. "This bias is the foundation of the whole stock-trading industry," says Kahneman. "Traders know that 50 percent of them must be below the median, but they all think that they're above average."
• Too timid. The average investor makes bold forecasts, but he is also risk-averse and makes timid decisions. His choices are unstable and he is quick to bail out of a situation.
• Too afraid of loss. How much a stock costs shouldn't affect your decision to sell it, according to the traditional model. But for real investors, how much they paid is very important. People hang onto their losing stocks because they don't want to feel the pain of admitting that they were wrong.
• Too quick to trade. Kahneman reports that a study shows that when an investor sells one stock and immediately buys another, the one that was sold does better by an average of 3.4 percent in the following year. People like to feel that they're actively bettering their financial situation—but, as Kahneman says, "if you hold onto a stock for a while, your chances of making money on it are greater."

Behavioral finance is changing the way the actions of entrepreneurs as well as investors are viewed. "We see entrepreneurs as people who are willing and even eager to take risks," he notes. "But in reality, successful entrepreneurs are usually those who are so overconfident that they don't even see the risks they're taking."