It is not uncommon for intelligent, competent people who have been successful in business or an academic environment to try their hands at trading on the markets. In essence, because they have managed to outpace the competition in the business or university sector, they think they can do the same with investments. However, while this logic may be appealing, it does not always pay off and many of these individuals lose money for a variety of reasons.

A Common Beginning and a Good Start
The German expert Jochen Steffens explains how this can happen (Investor's Daily, November 2004). In an example, Steffens describes a new "intelligent" investor named John. John is advised by a friend to put some of his money into the stock market. He does so and buys a very promising stock. In one month, he turns $30,000 into $35,000. All he had to do was phone in and place an order. John now believes he is on to a good thing. There are few other areas where you can make such good money with so little effort.

The problem is that John now thinks he can carry on doing this. His reasoning: "I am more intelligent than most people. I have proved that throughout my life. I can now use my knowledge and intelligence in the stock market to gain an advantage over all those other idiots out there who think they know what they are doing, but don't." This, says Steffens, is a fatal mistake.

Intelligence and education often guarantee success in academic professions and sometimes in business, but the world of investment is driven very differently. (To learn how to start investing for yourself, see our Investing 101, Stock Basics and Basic Financial Concepts tutorials.)

Things Start to Sour
John then buys another stock, but this time it does not go up, but down. John is very surprised. He researched extremely carefully on the internet and found all sorts of evidence to suggest that this particular share could only go up. But it didn't. John now makes the next fatal error. He believes that "all those idiots who are selling this stock just don't realize how much it's going to be worth over time! It's really a great buy, but only truly intelligent people can see this."

Unfortunately, all those "idiots" continue to sell and sell. The stock is now worth 60% of what John paid and he is faced with a nasty dilemma. He could accept that he is one of the idiots after all and sell. But this is difficult - John is keen to preserve his own self image as an astute judge of the market, companies and other investors.

Human (market) psychology being what it is, John looks for another reason why things went wrong. It could be Ben Bernanke, events in China, the weather or even the phase of the moon. Anything but the fact that John simply made a mistake, or a series of them. (To learn more, read How Investors Often Cause The Market's Problems.)

From Bad to Worse
Something else is very clear to John: the share has dropped so much, that it can't fall any farther. Therefore, John reasons that it's best to wait until his shares climb back to his purchasing price of $30,000. This is the next in this not-so-funny comedy of errors, because the stock continues to fall, eventually grinding to a halt at $15,000.

John now waits for that inevitable meteoric rise that will salvage not only his savings, but also his sense of self-esteem. However, the rise never comes, and the stock languishes between $15,000 and $17,000 for a year. Finally, our intrepid investor realizes it's game over and sells.

The Cycle Begins Again
Then, the truly inevitable happens. The company is taken over, restructured and streamlined with great skill and precision, the products remarketed and the stock starts to rise and rise. Our hero goes though stress and misery once again.

Now he realizes there is only one thing that he can rely on - cash is king. At least until our hero starts to get very frustrated when his friends, who are definitely not as intelligent as he is, tell him how much their portfolios are making.

The Market Takes from Everyone
Steffens' story of "Intelligent John" is largely a psychological one. John was subject to a series of emotions and their consequences, all of which are very common in the investment sector. John's "sure thing" plunged downward and he felt humiliated. In order to maintain his self image, he kept the stock way too long, hoping that all would be well in the end. Even worse, says Steffens, "he wanted to show the stock market who was boss.

However, the stock market does not care who it takes money from. Whether it be a construction worker, professor, doctor, politician, economist - or our poor intelligent John - is irrelevant. The illusion of control, self-overestimation and the classics of greed and fear are poison in the markets. The most intelligent and educated people are anything but immune to such "psychotraps". (To learn more about the psychology of investing, see Master Your Trading Mindtraps, When Fear And Greed Take Over and Mad Money ... Mad Market?)

As German behavioral finance expert Joachim Goldberg points out, "If people win a few times on the market, often with small amounts, they think: 'Now I know how it works,'" ("Strong Emotions Hamper Trading", Handelsblatt, October 2005). As a result, they start putting more and more into the market until things go horribly wrong.

Conclusion
When things take a turn for the worse, investors tend to make a classic series of mistakes: hanging onto stocks that are losers, selling far too late, then moving too much into cash. As Goldberg confirms,
"the most common errors are to act too suddenly on important trades, not to realize losses in time or to take profits too early."

Heinz Werner Rapp of Feri Wealth management in Germany adds that in 2000, as in other euphoric booms, the most obvious behavioral problem is that "people blind themselves to anything they don't want to hear" (Handelsblatt, October 2005). They refuse to believe or act on the simple truth proclaimed by independent experts. As such, as smart as they may be, they are destined for failure.

In 2000, the fundamentals of the new economy shares were hideously out of line with their stock market evaluations. Investors watched their stocks climb to dizzying heights and deluded themselves that the world had changed and that the party would go on forever. But the new economy was not so new after all - the cold realities of the old economy prevailed in the end, and they always do - even for the smartest investors.

Related Articles
  1. Term

    Three Ways to Profit Using Call Options

    A call option gives an investor the right, but not the obligation, to buy a stock at a specific price, known as the strike price.
  2. Term

    Understanding Rational Choice Theory

    Rational choice theory assumes an individual will always make prudent and logical decisions that yield the most benefits.
  3. Active Trading Fundamentals

    New Traders: Trade the Market in 5 Steps

    New traders shouldn’t throw money at securities without knowing why prices move. Follow these five steps to tilt the odds in your favor.
  4. Investing Basics

    The January Barometer: Is it Still Relevant?

    The January Barometer has been historically accurate. Will that be the case in 2016?
  5. Investing News

    Will China Slip Into a Recession?

    The Chinese economy is an entanglement of many factors gone wrong: an overvalued, engineered stock market, slow GDP growth and a devalued currency. What happens next and what will be the global ...
  6. Investing Basics

    How Advisors Can Help Clients Stomach Volatility

    Investing has its ups and downs, but financial advisers can do much to prepare their clients and their clients' portfolios for such volatility.
  7. Stock Analysis

    Looking for a Trade? Eye These High-Beta Stocks

    High-beta stocks are volatile, presenting profitable trading opportunities ... but not without risk.
  8. Active Trading Fundamentals

    The Best Sectors To Sell Short in 2016

    Three groups of stocks and sectors should underperform in 2016, generating profits from selling high and buying low.
  9. Term

    What Is Capitulation?

    Capitulation occurs when investors sell equity positions as quickly as possible.
  10. Investing Basics

    NYIF Instructor Series: Shark Watcher

    In this short instructional video Jack Farmer explains what a "Shark Watcher" is in the investing world.
RELATED FAQS
  1. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  2. How does days to cover a short position relate to a short squeeze?

    Days to cover a short position reveals the intensity and duration of a potential short squeeze. A short squeeze occurs when ... Read Full Answer >>
  3. Is it better practice to use a stop order or a limit order?

    Both stop orders and limit orders have their advantages and disadvantages; traders need to decide between the two based on ... Read Full Answer >>
  4. What is the difference between a buy limit and a sell stop order?

    A buy limit order is a specific type of buy order used to enter a market, while a sell-stop order is a sell order that can ... Read Full Answer >>
  5. What is the difference between a short squeeze and a long squeeze?

    A short squeeze and a long squeeze are situations that can force traders and investors out of their positions. A short squeeze ... Read Full Answer >>
  6. Why does the efficient market hypothesis state that technical analysis is bunk?

    The efficient market hypothesis (EMH) suggests that markets are informationally efficient. This means that historical prices ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center