Who is the average investor's worst enemy? It seems like a growing crowd of people would yell "AIG!" Some in that crowd might answer with some other names and a string of profanities, by which they mean "The politicians who enabled AIG!"
But neither answer is correct. The average investor's worst enemy never has been (nor ever will be) found on Wall Street. That enemy doesn't lurk in some boardroom. It's not a "missed opportunity" or "unforeseen event," either.
If you're an investor and you really want to meet your own worst enemy, simply go stand in front of a mirror and look straight ahead.
Too few investors understand this. Fewer still can grasp how they are their own worst enemy. "Self-inflicted wound" is a fitting analogy, but if you need a more scientific phrase, the best one is "cognitive bias."
Put simply, cognitive biases are errors in perception -- certain beliefs or emotions that literally alter our perception and memory. For example: Suppose that two people take a test, and that it takes a high level of competence to earn a good test score. One person earns that good score, while the other does not.
When asked to estimate their test scores, who do you think typically underestimates their performance – the competent or the incompetent individual?
Competent people will underestimate their scores – and, alas, incompetent individuals will consistently overestimate theirs. This is what two psychologists from Cornell University showed in an article titled, "Unskilled and Unaware of It."
This particular problem is the "overconfidence effect" (i.e., wishful thinking). Unfortunately, the varieties of cognitive bias make for a long list. One of the best documented is the "bandwagon effect," or the tendency to follow the choices of others -- it's the one that leads to performance chasing, and the creation and bursting of financial bubbles.
"Hindsight bias" is another common error in perception: you remember decisions that led to positive outcomes, but forget decisions with less favorable results. A related error is "confirmation bias," or filtering information in a way that confirms what we already believe.
Now, all these cognitive biases may tempt you to just go stuff your money in a mattress. Bad idea. There are proven investment methods you can learn -- and learn to use well. Obviously, any "method" worthy of the name will include a way to assess risk: my point in all of this is that no method can succeed until investors realize that the greatest risk they face is the one they pose to themselves.
Elliott wave analysis can't magically instill self-discipline, but it can help you recognize patterns in the market -- particularly the highs, lows, and dominant trends that reveal the collective emotions of others. It can also be the first step toward recognizing those emotions, instead of participating in them.
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