How many of us are willing or inclined to admit that we are less than competent or average in handling our investment decisions? Very few investors are willing to admit that they are average. This invariably leads to investors overestimating their predictive skills. The concept of overconfidence leads to two fundamental mistakes: One, it makes investors naively believe that they can time (enter at a low level and exit at a high level) the market better than another average investor. Two, it leads to excessive trading. This is a destructive habit most experienced investors pick up along the way. It has been consistently proven that "a buy-and-hold" strategy of a diversified portfolio is the best bet for individual investors in the long run.

A good proportion of investors holding a losing position find it difficult to sell out and cut losses. Fundamentally, an investor's ego refuses to acknowledge an error of buying a stock at a high price. This leads them to cling to stocks in the fond hope that some day in future the stock price will reach their purchase price and vindicate their purchase. There is no better example of this behaviour than investments in software stocks. Thousands of investors (if not more) must have acquired software stocks in the 1999-2000 peak, and are perhaps still clinging to them without cutting losses though the fundamentals in the sector have undergone a sea change in the past two years.

Investor psychology has also shown that there is a tendency to throw good money after bad immediately after incurring losses, either in the same sector or other sectors. It has been found that losses coming immediately after another is less painful than at a different occasion.

There is a flip side to this psychology as well. Even as investors cling to their losses, they tend to book profits in the winning stocks too soon, without allowing the upside to accrue fully. This is mainly because avoiding a loss tends to dominate investment decision making rather than potential profits. Only experienced investors with discipline have managed to overcome this hurdle.

An investor tends to organise his/her investment portfolio into separate "mental accounts". And studies have shown that it does lead to inefficient decision making in portfolio allocation. For instance, given a choice of churning a portfolio, they may be arbitrary in their risk allocation, say, switching between low-risk bonds to high-risk equity, without justification. Or, say, in portfolio rebalancing, they may sell stocks in a profitable position first as opposed to stocks recording losses.

Investor psychology tends to vary with experience. Novices or less experienced investors tend to extrapolate past trends into the future, without full or relevant information.

This may take the form of either financial performance or prices or trading patterns in stocks to make an investment judgment. At times, lack of experience locks them into a certain investment positions at an overvalued level when a price trend is about to reverse. On the contrary, the more experienced investors — realising that extrapolation is dangerous — attempt to outguess a trend reversal ahead of the overall market. This sometimes lands them in a losing investment position. In a complex market riddled with uncertainty, experience (without self-control and discipline) can be a double-edged sword.

Investors have to guard against theme-based rallies — whether they are in software, pharma or PSU or banking.

These rallies invariably look different from the previous occasion, but the underlying "madness of crowds" or investor overreaction always takes a toll. For that matter, even investing in respected blue chips (from the BSE Sensex or Nifty stocks) can be as prone to investor overreaction as any of theme-based rallies.

Though it may be comforting that money was lost in overvalued blue chips, remember it is money lost forever.

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