Chapter 25. How Much Psychology Should You Know?

The dumbest reason in the world to buy a stock is because it's going up.[187]

Warren Buffett

Many investors make dumb decisions by chasing stock prices. Do you? If so, what can you do about it? We will get better answers by studying psychology than by boning up on finance alone. The fascinating field of psychology is no longer limited to human behavior in social settings. In recent years, behavioral finance has shed light on the psychology of stock prices and financial decisions by market participants. Essentially, two main forces affect stock prices in the market: the fundamentals of the company and human behavior. Both forces have a role to play. However, a combined knowledge of the two should make a more powerful foundation for making intelligent decisions in the stock market than relying on fundamentals alone. Since a long discussion of psychology will take us away from our main goal of becoming better investors, only issues that are important from an investing point of view will be covered here.

Herding and You

You do not need a degree in psychology to understand that in the short run, the price of a stock can deviate substantially from its basic value because market participants may betray a herd instinct in their behavior. This is probably the most important concept that you need to know about market psychology. When people do not understand a company well, they follow the crowd: They chase the winners and dump the losers indiscriminately. ...

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