Tuesday, April 6, 2010

Don't Let a Market Rally Cloud Your Judgement

When the market is acting as it is right now - going up more than it is going down - it is very easy to enter a very dangerous emotional state. I believe that psychologists call it the "recency effect". Let's look at a definition of what that means.

Wikipedia has recency effect as the follows:

The recency effect, in psychology, is a cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end on a list rather than items that were in the middle on a list. For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, they are likely to conclude there were more red cars than blue cars throughout the drive.

In other words, we think that what we have seen or experience more recently is the way things are and will continue to be. When it comes to the stock market, this can be especially dangerous.

The reason for this is that when the markets are acting well and going up and up, then our minds interpret this as the way things must be and worse, will continue to be. It creates a sense of complacency in us where stupid mistakes are made.

It took me a long time to realise that this human behaviour impacts my own investment performance. I can not say I no longer suffer from it, but I know that I have learned to question those times when it seems like the markets can only go up. That way I make decisions on what is right for my portfolio as opposed to what is right for the market at that given time.

This article was written by The Dividend Guy. To learn more about dividend investing, please follow my RSS feed or Twitter account.

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