Behavioural Risks

Sunday, November 28, 2010

Investment Madness

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.

Our very own psychological biases have an impact on our investment decisions and affect our attempts at building wealth.

Psychological Bias	Effect on Investment Behavior	Consequence
Overconfidence	Trade too much. Take too much risk and fail to diversify	Pay too much in commissions and taxes. 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 and your investments
Status Quo	Hold back on changing your portfolio	Failure to adjust asset allocation and 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 get break even	Susceptible to big losses
Social Validation	Feel that it must be good if others are investing in the security	Participate in 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 and safer	Failure to diversify and put too much faith in the company in which you work

If you want to read more regarding human psychology and how it affects our trading and investment, please read the book “Investment Madness How Psychology Affects Your Investing and What to Do About It” by JOHN R NOFSINGER

http://mystocktrader.blogspot.com/2010/11/investment-madness.html