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Tuesday, July 05, 2005

The Psychology Behind Common Investor Mistakes

The Big Picture writes about the important role of psychology in stock markets. You really should read this post, it's excellent.

Six common errors of perception and judgment, as identified by psychologists, are examined in this article: overconfidence, fear of regret, cognitive dissonance, anchoring, representativeness, myopic risk aversion.

The original article was published in AAII Journal, by R. Douglas Van Eaton, CFA, a professor of finance in the College of Business Administration at the University of North Texas in Denton, Texas.
Behavioral finance, a relatively new area of financial research, has been receiving more and more attention from both individual and institutional investors. Behavioral finance combines results from psychological studies of decision-making with the more conventional decision-making models of standard finance theory.

A leading researcher found that when analysts are 80% certain that a stock is going to go up, they are right about 40% of the time. You can profit from this research only by heeding its message: Trade less. This is perhaps more easily said than done.

Fear of Regret
Studies have shown that people will postpone a decision, claiming that they are awaiting an upcoming information release, even when the new information will not change their decision. In stock transactions, acting so as to avoid the pain of regret can lead to holding losing stocks too long and selling winners too soon.

Understanding the role of anchoring in the decision-making process can help you avoid some investment pitfalls. "Bottom fishing," the practice of buying stocks that have fallen considerably in hopes of getting them cheaply, can be quite hazardous to your wealth. The motivation behind this strategy is similar to the concept of anchoring. A higher recent price is taken as evidence of value, so that the new price seems cheap.
Read further:
The Big Picture: The Psychology Behind Common Investor Mistakes


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