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When we go to the grocery store, we seldom shop on logic alone. We may not even buy on price. We buy one type of yogurt over another because of brand loyalty or because one brand has more appealing packaging than another. We buy five bananas because they are on sale for 29 cents this week - the bargain is right there, why not seize the opportunity? We pick up that gourmet ice cream that everyone gets. If everyone buys it, it must be a winner.
As casual and arbitrary as these decisions may be, they are remarkably like the decisions many investors make in the financial markets.
A degree of emotion also factors into many of our financial choices. There is even a discipline devoted to how our emotions affect our financial decisions: behavioral finance. Examples of emotionally driven financial behaviors are all around us, especially in the investment markets.
Behavior No. 1: Believing future performance relates to past performance. In truth, there is no relation. If an investment yields 8 percent to 10 percent for six consecutive years, that does not mean it will yield 8 percent to 10 percent next year. Still, we may be lulled into...