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Psychological/Behavioral Investing Pitfalls

 

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There are many well-documented psychological biases which adversely affect our financial decision-making and which we are all occasionally subject to.  If you know what they are, you may be less likely to be adversely affected by them.  Here's a list of several of them:
 
bulletMental Accounting.  This is the tendency to value some dollars less than others.  One example of this is the "House Money" effect: if you are gambling at a casino and you have been fortunate enough to win, you might tend to be more risk-seeking with your earnings than you would be with your principal.  For more information, see the excellent paper here (2.4mb).
bulletLoss Aversion.  This is the tendency to feel more pain by losing money than you would feel satisfaction in gaining an equal amount of money.
bulletMyopic Loss Aversion.  This is the tendency to focus on avoiding short-term losses, even at the expense of long-term gains.  For example, this explains why people tend to buy insurance policies with low deductibles and low limits, despite it being opposite to what is clearly in their long-term best interests (i.e., most people would be best served with high deductibles and high coverage limits).  For more information, see the excellent papers here (1.1mb), or the excellent article here.
bulletSunk Cost Fallacy.  This is the tendency to "throw good money after bad."  It is related to Regret Aversion and Loss Aversion.
bulletStatus Quo Bias.  This is the tendency to want to keep things the way they are.
bulletEndowment Effect.  This is the tendency to consider something you own to be worth more than it would be if you didn't own it.
bulletRegret Aversion.  This is the tendency to avoid taking an action due to a fear that in hindsight it will turn out to have been less than optimal.
bulletMoney Illusion.  This is a confusion between "real" and actual changes in money (i.e., time value of money and inflation effects).
bulletBigness Bias.  This is the tendency to pay more attention to big numbers than small numbers (e.g., we are more impressed by the fact that a particular mutual fund had a 50% return last year than we are discouraged by the fact that the same fund has an expense ratio of 3% and a sales load of 5%).
bulletThe Law of Small Numbers.  This is the tendency to exaggerate the degree to which a small sample resembles the population from which it is drawn.  This is related to the Recency bias.
bulletRecency Bias.  We tend to associate more importance to recent events than we do to less recent events (e.g., during the great bull market of '95-'99, many people implicitly presumed that the market would continue its enormous gains forever, forgetting the fact that bear markets have tended to occasionally happen in the more distant past).  This is related to the Law of Small Numbers.
bulletAnchoring.  This is clinging to a fact or figure that should have no bearing on your decision.  Often, we use an initial value as a "starting point" in decision making.  Even if the initial value was a totally random uneducated guess, we tend to be biased towards it.
bulletConfirmation Bias.  This is the tendency to look for, favor, and be overly persuaded by information that confirms your initial impressions.  Conversely, we tend to ignore and dismiss information which tends to disprove our initial impressions.  For more information, see the outstanding discussion here.
bulletOverconfidence.  This is the tendency to overestimate our own abilities (i.e., we aren't as smart as we think we are).  People tend to think that they are much better forecasters and estimators than they actually are.
bulletOptimism.  People tend to be optimistic about the future.  This might also be termed, "wishful thinking."
bulletInformation Cascades.  This is the tendency to ignore our own objective information and instead focus on emulating the actions of others (e.g., the tendency to sell a stock solely because others are bidding the price down, or buying a stock solely because others are bidding the price up).  This is also known as "herding."  For more information, see the discussion here or the papers here and here.
bulletFalse Consensus.  This is the tendency to think that others are just like us.
bulletWeakness of Will.  This is the tendency to consciously do things which we sincerely know are wrong.  A non-financial example includes smoking cigarettes (we know we shouldn't do it but many do it anyway).  A financial example includes living within our means (we know we should do it, but we often don't).
bulletCredulity.  While we might like to believe that we are all perfectly rational, reality is far different.  Unfortunately, we tend to be susceptible to the manipulative messages that the financial industry and the popular press put out.  Specifically, mutual fund companies tend to conspicuously advertise positive information, while suppressing negative information.  The popular press encourages conventional wisdom on investing issues because it helps them sell magazines (despite being provably wrong).

For more information, see the articles on Investor Psychology/Behavioral Finance in our Reading Room.  Also, see the following excellent books:

bulletGary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes and How to Correct Them, (Simon & Schuster, 1999).
 
bulletNassim Nicholas Taleb, Fooled By Randomness: The Hidden Role of Chance in the Markets and in Life, (Texere, 2001).
 

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This web page contains the current opinions of Eric E. Haas at the time it is written and such opinions are subject to change without notice.  This web page is intended to serve two purposes:

bulletTo educate the public; and
bulletTo provide disclosure of Mr. Haas' opinions to prospective clients.  We believe that prospective clients are well-served by being made aware of what they are buying and what they are buying is advice that is based on these opinions.

We believe the information provided here to be useful and accurate at the time it is written.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

No investor should invest solely on the basis of information listed here.  Before investing, it is important to consult each prospective investment's prospectus and consider both its risk/return characteristics and its effect on your overall portfolio.

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