Important lessons to understand the stock market

Emotions can adversely influence our investment decisions and lead to irrational behaviour, according to a new study by Franklin Templeton Investments.
Many a time, one's emotional response is so instantaneous that one is unaware it is even occurring. And experts say a small little part of our brain called the amygdala may play a key role in our bad decisions.
It functions as the brain's early warning system, sending out messages of fear and anxiety to raise the alert of imminent trouble. This may cause us to regard negativity and pessimism as accurate.Understanding our emotional state and putting plans in place before emotions take over can help prevent poor investment decisions. The Franklin Templeton Investments report found five common mistakes made by investors, which can be easily avoided:

Loss aversion

This refers to the deep pain investors feel upon taking a loss and the lengths to which they will go to avoid that pain.
A study by psychologists Daniel Kahneman and Amos Tversky found that between a certain loss of US$3,000 (S$3,675), and an 80 per cent chance of losing US$4,000 and 20 per cent chance of losing nothing, more than 90 per cent of investors polled picked the latter, even though statistically it was the riskier proposition.
Since the global financial crisis- led market meltdown in 2008, many investors have been reluctant to buy equities out of loss aversion. They have preferred to remain in low-yielding vehicles that may deliver a negative real return after inflation.

Holding on to the past

Stock markets reflect the tendency of investors to anchor expectations to a given price. For example, a stock will typically trade for a while within a given range, then trend up or down to a new anchor level and trade within that new range.
Investors adjust expectations to the altered price, which is why overly sharp gains or losses provoke discomfort.
The sensitivity shown to price changes may be largely the result of memory for prices paid in the past, and not at all a reflection of true preferences or level of demand.

Following the crowd

A modern example of how the herd mentality can go seriously wrong is the dot.com phenomenon of 2000.
While the significance of the Internet was real and enduring, many of the companies into which investors poured their money were neither.
So, following the crowd can be a precursor to market bubbles, as what begins as a natural inclination to join in the growth path of a company can end in losses as the euphoria of explosive price increases causes investors to lose their sense of judgment.

Availability bias

Rather than analysing all the relevant information, investors tend to rely on whatever data is most recent or emotionally charged.
This can cause them to overreact to market conditions, whether positive or negative, or invest in a stock simply because it has been heavily covered by the media.

Mental accounting

Many investors practise mental accounting when they lock in certain assets for retirement, maintaining somewhat greater liquidity for controlled wealth accumulation, or allocating a smaller sum for high risk-high reward investments.
However, this compartmentalising means investors may also take unwarranted risks with their own money, or may be overly cautious with an inheritance.