Learn to invest with Buffett

Chapter 92

Chapter 15 Section 4 Don't Overreact

The tendency to overreact is very harmful. It will not only destroy your peaceful and orderly life, but also greatly affect the accuracy of your decision-making.

--Warren Buffett
Regarding the overreaction, the foreign unified theory model explained it.The unified theory model assumes that the market is composed of two kinds of bounded rational investors, namely "news observers" and "trend traders".News watchers base their forecasts on information they have, not on information about prices.Trend traders are just the opposite, they only base their forecasts on recent price changes and they don't care about other information.The model assumes that private information gradually diffuses among information observers, and then trend traders intervene to cause the price to peak, and then the price reverses, which is an overreaction.If the overreaction of investors forms a combined force, it will cause a sharp shock to the entire stock market.

Psychologists have also observed an "overreaction bias."Investors react excessively and aggressively to bad news, while reacting relatively slowly to good news.Once the short-term profitability of the stocks of the companies they invest in is not good, investors will react quickly and overreact, resulting in an inevitable impact on the stock price.We call this phenomenon of overemphasizing short-term profits the overreaction psychology of investors.

A 1979 issue of BusinessWeek asked, "Are stocks dead?" Shortly thereafter, an 18-year stock bull market officially began.More recently, Barron's, in a late 1999 issue with Warren Buffett on its cover, asked, "What the hell, Warren?" and bemoaned Buffett's aversion to technology stocks.But three years later, the Nasdaq has fallen by more than 60%, and Berkshire's stock has appreciated by 40%.

Some investors are particularly inclined to lock in on the latest news they receive, and then rush in to try and make a big buck.In their minds, the latest profit figures are a signal of greater profits in the future. At the same time, they also believe that what they see is a future prospect that others have not seen. With this superficial reason, they quickly make decisions. The investment decision and investment behavior of aggressively entering the market.Human overconfidence is of course the instigator behind this investment behavior, because investors believe that they understand the stock market better than others, and interpret this information better than others.But the fact is often not the case.Overconfidence led to overreaction, which made the market situation worse.

According to behavioral scientists, people respond to the pain of loss far more than the pleasure of gain.It takes twice as much positive influence to overcome twice as much negative influence.In a 50:50 bet, if the chances are absolutely equal, people will not take the risk easily unless the potential profit is twice the potential loss.

This is the psychology of overreaction: adverse situations have more influence than favorable situations, which is a basic principle of human psychology.Applying this principle to the stock market means that investors feel twice as bad about losing money as they do about making money by being right.This thread of thinking can also be found in macroeconomic theory.In macroeconomics, consumers typically shop 1 cents more for every dollar of wealth they create during an economic boom, but spend 3.5 cents less for every dollar they lose in the market during a recession.

The overreaction is reflected in investment decisions, and its impact is significant and profound.We all want to believe that we are making the right decision.In order to maintain a correct view of ourselves, we always hold on to the mistakes and choose to let go, hoping that someday things will turn around.If we don't sell the stocks that will generate losses, we will never have to face our failure.

Excessive psychology also makes investors overly conservative.People who participate in retirement fund account plans, their investment period is 10 years, but they still invest 30% to 40% of their funds in bonds.Why is this?Only a grossly excessive loss psychology would cause a person to allocate his investment funds so conservatively.But excess psychology can also have an immediate effect, causing you to cling to losing stocks for no reason.No one wants to admit that they made a mistake.But if you don't sell the wrong stocks, you're effectively giving up the chance that you could invest wisely and profitably again.

In real life, few investors are able to stand firm and resist the overreaction generated by the signal of falling prices, and they also lose the benefits of turning "losers" into "winners".But there are also investors who can keep their cool when people overreact.

In the field of investment, your opponent may be a huge market composed of countless people.It is impossible for you to react faster than the market every time, all you have to do is to do it in your own way.

Investment motto:

How many investors can take a stock price drop, especially if it falls violently, with aplomb without any undue emotional reaction?When these declining stocks start to perform well again, few people can keep up with this trend and buy them back quickly.So, avoiding overreaction requires a kind of wisdom.

(End of this chapter)