Psychological Biases and Investing

December 27th, 2007 | by Brian |

I recently finished reading a book about this called Investment Madness, by John R. Nofsinger, an Associate Professor of Finance at Washington State University. It’s very clear, well-organized, well-referenced, and a quick read. The publisher has put the first chapter on-line here. From the introduction:

We are all prone to having psychological preconceptions or biases that make us behave in certain ways. These biases influence how we assimilate the information we come in contact with on a daily basis. They also have an impact on how we utilize that information to make decisions.

Some of the decisions that are influenced by our psychological biases can have a large impact on our personal wealth—or the lack of it. I have written this book to try to show you how your own psychological biases can creep into your investment decisions and sabotage your attempts at building wealth.

In last chapter Nofsinger summarizes the biases in a handy table, which I reproduce here:

Psychological Bias	Effect on Investment Behavior	Consequence
Overconfidence	Trade too much	Pay too much in commissions and taxes
Overconfidence	Take too much risk and fail to diversify	Susceptible to big losses
Attachment	Become emotionally attached to a security and see it through rose-colored glasses	Susceptible to big losses
Endowment	Want to keep the securities received	Not achieving a match between your investment goals & your investments
Status Quo	Hold back on changing your portfolio or allocation and begin starting your 401(k)	Failure to adjust asset allocation & begin contributing to retirement plan
Seeking Pride	Sell winners too soon	Lower return and higher taxes
Avoiding Regret	Hold losers too long	Lower return and higher taxes
House Money	Take too much risk after winning	Susceptible to big losses
Snake Bit	Take too little risk after losing	Lose chance for higher return in the long term
Get Even	Take too much risk trying to break even	Susceptible to big even losses
Social Validation	Feel that it must be good if others are investing in the security	Participate in a price bubble which ultimately causes you to buy high and sell low
Mental Accounting	Fail to diversify	Not receiving the highest return possible for the level of risk taken
Cognitive Dissonance	Ignore information that conflicts with prior beliefs and decisions	Reduces your ability to evaluate and monitor your investment choices
Representativeness	Think things that seem similar must be alike. So a good company must be a good investment.	Purchase overpriced stocks
Familiarity	Think companies that you know seem better & safer	Failure to diversify and put too much faith in the company in which you work

Travis Morien (linked in the table) has a good section on investment psychology here. A book I read a few years ago, Why Smart People Make Big Money Mistakes, is also worthwhile. Cornell U. Psychology Professor Thomas Gilovich is a coauthor, and also wrote How We Know What Isn’t So, which I also enjoyed.

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