Whether it's the Dutch tulip craze of the 17th century, the dot-com mania of the late 1990s, or the most recent rush into real estate, there's no shortage of examples of investors behaving irrationally.
In the world of traditional economists and finance professors, though, that's not supposed to happen. If investors are rational decision-makers, then emotion-driven bubbles shouldn't be possible. Yet human weaknesses can limit our ability to think clearly. Many studies of investor behavior have shown that investors are too willing to extrapolate recent trends far into the future, too confident in their abilities, and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interests.
... According to several studies, overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. And all that trading can be hazardous to your wealth, as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behavior. The study looked at approximately 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualized return of 11.4% over that time, while inactive accounts netted 18.5%. Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns.
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