More Straight Talk on Investing

18Why You May Be Your Own Worst Enemy

Economist Benjamin Graham once said, “The investor's chief problem—and even his worst enemy—is likely to be himself.” The quote captures perfectly that tendency for investors to act irrationally and in ways that are contrary to their own interests.

Over the past few decades, an entire academic discipline has sprung up on this topic—behavioral finance, which is the study of the influence of psychology on investor behavior. Scholars have written dissertations on how people make investment choices, and several universities have established endowed professorships in the field. Researchers in behavioral finance apply scientific methods to analyze behavior that has been observed anecdotally for a long time.

While we investors would like to think we always carefully weigh our options and sensibly choose the ones that offer the most benefits, the fact is that we often don't. It turns out that real people aren't very good at even identifying options, let alone choosing the right one. We tend to misinterpret information and miscalculate simple statistical probabilities. And we react to events in emotional and often counterproductive ways.

Although I haven't formally studied investor psychology, I have had the opportunity over the years to observe many investors, both successful and not-so-successful ones. My experience bears out some of what the behavioral finance experts have been telling us. On the basis of how real people react to real events ...