Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.
—Jason Zweig
Why do generally sensible people sometimes make foolish decisions involving money and investing? A major reason is that they have psychological biases and make predictable cognitive errors. These problems are inherent in everyone’s thinking process, but some people are more susceptible than others to their influence. Knowledge and experience help to reduce the influence of behavioral biases on financial decisions. This chapter is intended to help give you that knowledge by informing you about these self-inflicted pitfalls and how to avoid them.
Behavioral biases occur for several reasons. These problems come from limitations in such areas as memory, attention, knowledge, and time. Various cognitive errors occur because the human brain is subject to these limitations. When the thinking process attempts to simplify its information processing, it often creates predictable biases in the judgments. Investing decisions are particularly vulnerable to behavioral biases because they involve much uncertainty. Since investors don’t know what will happen in the future, they lack all of the information needed when analyzing investment choices. Without having the necessary information, the cognitive process must “fill in the gaps” to reach a conclusion. In other words, your brain takes a shortcut. This mental shortcut, also called heuristic simplification, helps in forming judgments, but also has inherent biases that are problematic for financial decision making.
Another source of behavioral bias is your emotions. The media love to frame investors in terms of fear and greed. You might hear, “The market fell because of panicked investors.” But emotions are much more complicated than that simple characterization. For example, other factors influence investment decisions such as regret, pride, optimism, and self-image. Nevertheless, you’re better off making non-emotional, rational decisions involving your money. Lastly, other people may influence your decisions. Different groups develop norms that provide social pressure to inform and conform. The company you keep partly determines your investment decisions and thus your wealth.
In summary, this chapter reviews the behavioral biases that lead to foolish investing decisions. Savvy investors avoid these self-inflicted wounds by mastering their personal psychology. You can’t control the market or the future, but you can exert control over yourself.
Traditional finance purports that people are risk averse. In the investment context, risk aversion means that you prefer not taking risk unless you expect to be fairly compensated for the risk. In other words, you want a higher return for investing in riskier investments. However, people exhibit loss aversion more frequently than risk aversion. Loss aversion refers to the tendency to hold onto assets that have fallen in price rather than realize the loss by selling. Taking a loss by selling can result in much mental anguish. Investors typically feel the pain of a loss more strongly than the pleasure of a gain. For example, you’re likely to feel more pain after losing $1,000 than you feel joy from having a $1,000 profit. The pain of losing is psychologically about twice the magnitude as the pleasure of an equivalent gain.
Clinging to losers involves two major problems. First, the falling prices of many investments occur for good reasons and could continue their downward spiral. Second, better investments may be available. Thus, you may be missing out because your capital is tied up in a loser. Loss aversion can have a powerful influence on decision making. Indeed, investors often go to great lengths to avoid taking a loss. Some investors may begin the “average down strategy” and buy more shares at a lower price just to lower the average purchase price.
An example of going to extremes to avoid a loss is when you have an opportunity to break-even. The desire to turn a losing position into a break-even position causes some investors to take risks and gambles they wouldn’t ordinarily take, called the break-even effect. For instance, you may feel that, “if this stock price returns to what I paid for it, I would sell it!” That isn’t a convincing reason to hold a stock. But a powerful draw exists to getting even. Studies show that people aren’t normally willing to take very risky gambles, but they’re willing to take those risks if they have a chance to break even. Because investors who have lost money want to make up their losses, they may take bets that they otherwise wouldn’t have taken.
Of course, real-life events can be complicated. Determining whether you should consider some investments a profit or a loss might be difficult. Assume that you bought a stock for $50 per share. At the end of the year, the stock is trading for $100. At this time, you review all your investment positions to determine your net worth and monitor your progress toward meeting your financial goals. Six months later, the stock’s price falls and you could sell it for $80 per share. Do you view this situation as a profit or a loss? This issue deals with a reference point, which is the stock price that you compare with the current stock price. If your reference point is the $50 purchase price, then you believe that you made a profit of $30 per share. However, if you updated the reference point to $100 at your year-end review, then you may view the sale as a $20 per share loss. The brain’s choice of a reference point is important because it determines whether you feel the pleasure of obtaining a profit or the pain of a loss. If you believe the current price represents a loss, then your loss aversion may cause you to keep the stock at that $80 price.
One approach to dealing with loss aversion is to review the investment’s merits. Does the investment still have the characteristics that induced you to buy it in the first place? Would you consider buying more now that the price has fallen? If not, you might consider selling it. Still, loss aversion makes selling a loser difficult to do. In some cases, you can reframe this situation so that it feels like selling the loser gives you some value. For example, taking a loss on this position allows you to offset a capital gain you might have incurred from selling another asset for a profit. Profits can cause a tax liability. You can reduce that tax liability by offsetting the gains with losses. Thus, selling a loser can reduce your taxes. Thinking about tax reduction helps to sell losers. Lastly, you can bundle several trades. For example, selling winner and loser positions together allow you to feel good about the winner, which offsets some of the regrets from the loser.
You face two kinds of regret − the regret of omission and the regret of commission.
Regret of omission. The regret of omission is the bad feeling associated with not taking an action. For example, you could regret not buying Microsoft, Apple, or Amazon when each firm’s stock price was low. Or you could regret not selling a stock you own before it declined in price.
Regret of commission. The regret of commission is the bad feeling associated with taking an action that turn out poorly. For example, you could feel regret for buying a company’s stock that subsequently went bankrupt.
The pain you feel for the regret of commission is much stronger than the pain for the regret of omission. Thus, regret aversion is the indecision and failure to act due to fear of bad outcomes to avoid the emotional pain of the regret of commission. For example, consider that a stock you bought at $100 per share dropped to $60. Clearly, you regret buying it. But you now face two new regrets. You could sell the stock and take a $40 loss per share. If the price increased, you would regret (commission) having sold it at a low price. Or, you could hold the stock. If you do, the stock’s price could fall even more and you would regret (omission) not having sold it. Because the regret of commission is stronger, your regret aversion is likely to push you to continue holding the stock.
Regret aversion bias and loss aversion bias also result in the disposition effect, which suggests that people are predisposed to sell winning assets (prices have risen) too soon, while holding assets of losers (prices have fallen) too long. Two strong emotions – pride and regret – play a key role in the disposition effect. People avoid actions that will cause the pain of regret. Alternatively, they want to take actions that cause good feelings associated with pride. Seeking pride and avoiding regret when making investment decisions explains the disposition effect because it feels good to sell a winner but selling a loser causes regret. Thus, when you want to sell stock to raise capital for another investment, if both a winner stock position and a loser stock position is available in the portfolio, you’re about twice as likely to sell the winner.
Two reasons help to explain why this bias hurts your profits. The first is due to capital gains taxes. If you live in a country that taxes realized capital gains, then selling the winner creates a tax liability. If you hadn’t sold the winner, you could defer those taxes to a later year when you eventually sell. Also, selling the loser results in a loss that can offset other capital gains realized that year. That is, selling the loser could lower your tax bill. The second reason that the disposition effect harms profits comes from the tendency to sell winners too soon and hold losers too long. The ‘too soon’ part of the selling definition occurs if the winner stock sold continues to outperform the market for many months, even years, after you sell it. In other words, the stock was a good investment and would have made you more money. The ‘too long’ part of the holding definition occurs if the loser stock held continues to underperform the market for a while. Research shows that people really do sell winners too soon and hold losers too long.
To avoid regret aversion, try to take a broader view of the situation. In your analysis, don’t just focus and past returns, consider expectations for both future returns and your tax liability. Would you buy the stock at today’s price? If not, it’s time to sell. Remember that not making a decision is actually a decision.
People face a lifelong struggle between decisions that make either the present or future more pleasurable. For example, you could go on a vacation today or invest the money for your future. In general, people like to receive rewards early and to defer unpleasant tasks. Self-control bias is the lack of self-discipline in the short run at the cost of pursuing long-term goals.
Self-control bias may lead to several ineffective investment behaviors:
People may spend more today at the expense of saving for tomorrow.
Investors may try to make up the shortfall by assuming too much risk.
Delaying pursuing long-term goals represents inadequate planning for retirement.
People avoid the investing necessary for the future because they don’t want to sacrifice short-term benefits.
The immediate gratification mindset urges people to want to live as well as possible today but pay for it later.
You should strike a careful balance among short-, medium-, and long-term goals to reduce self-control bias. You can also strengthen your willpower through following rules of thumb. Rules like “buy low, sell high” help investors refocus on the basic investment strategy. Keeping focused on the long-term goals is embodied in “stay the course.” Saving and investing for your future becomes easier with “save much, don’t touch.” Finally, “pay yourself first” is a strategy to set aside a certain amount of funds at the beginning of each month, rather than to wait to see how much money is left at the end of the month.
Psychologists have determined that people exhibit two aspects of overconfidence bias: miscalibration and a better than average attitude.
Miscalibration. Miscalibration is the phenomenon that people are too sure of their knowledge and, therefore, don’t provide for enough chance of being wrong. This concept is important for investing because all decisions involve both knowledge and uncertainty.
Better than average attitude. The better than average attitude refers to over-estimating your own judgments and abilities. This ego-based attitude is symbolized by asking how well people drive a car and finding that most people believe they’re above average. Because the majority of people can’t be above average, many drivers are overconfident. Overconfidence bias leads to two serious problems for investors – too much trading and too much risk.
If you believe you’re an intelligent, knowledgeable investor, then how would you implement those skills? Would you buy some stocks and hold them for a long period? Or would you frequently buy and sell to catch the upside of some stocks while avoiding the downside? Overconfident investors want to exhibit their perceived skills and trade frequently. Unfortunately, trading is hazardous to your wealth. It involves commission costs and elicits emotions and bias that lead to buying high and selling low. Studies show that the more individuals trade, the lower their net return. Besides excessive trading, overconfident investors take too much risk because they hold under-diversified portfolios by owning too few stocks and stocks that are too similar. Overconfident investors may consider diversification to be too passive of a strategy. Afterall, they have great knowledge and investing skills, so they don’t need to reduce risk through diversification. But overconfident investors are wrong! This view partly stems from their miscalibration that underestimates the downside of the investments they buy while over-estimating the upside potential.
You have easy access to enormous amounts of information. Because of this information, you may mistakenly believe you have wisdom. Investment information can lead to knowledge when you have the right skills to properly interpret the information. Knowledge can become wisdom when coupled with experience. Many people have information – few have wisdom. The tendency to think that having information must lead to wisdom is called the illusion of knowledge. Additionally, some information appears important but is really irrelevant. One example is betting on the results of a fair coin flip. The past pattern of heads and tails may seem like important information, but it isn’t. No matter the past pattern, the next flip of a fair coin has a 50% chance of being heads. Knowing the past head/tails pattern seems like having knowledge, but that’s an illusion.
When armed with the illusion of knowledge, overconfident investors believe they’re better than the experts and can beat the market or pick superior stocks. The odds overwhelmingly favor institutional investors because they really do have better quality information and training. For example, most individuals get filtered information. That is to say, they get information that has been packaged by so-called financial experts in the media. Alternatively, institutional investors have access to the raw unfiltered data and have the training to properly analyze it.
If you aren’t familiar with the characteristics of a topic, you’re likely to transfer the characteristics of something similar that you know. For example, when looking at a used car, you may not know much about engines. But you can see the condition of the interior is spotless, which is a positive characteristic. As a result, you may transfer this positive characteristic to the engine and assume it works well. Used car salesmen know this too, so they clean up the appearance of a car and don’t work on the engine. This transfer of characteristics from a known item to an unknown one is called representative bias, also called the representativeness heuristic. This bias is comparable to relying on stereotypes. Assuming that a car that looks good also runs well could be a costly stereotype.
Identifying an investment that would be considered good in the future is difficult. However, you can more easily identify a good company. Good companies have good financial performance. Do good companies make good investments? The representativeness bias influences your thought process to make you believe that good companies will be good investments. However, stocks of good companies may be overpriced, thus making them poor investments.
Another common instance of representativeness bias is using past performance to form expectations about future performance. For example, investors like to buy the best-performing stocks and mutual funds over the last year or quarter. They extrapolate those high past returns into the future. Unfortunately, last year’s winners are rarely this year’s winners. When investors exhibit extrapolation bias, which is related to representativeness bias, they tend to overestimate recent events when making decisions about the future. Despite evidence to the contrary, investors continue to chase performance. They even extrapolate the performance of the overall market as their predictions for the future. For example, when asked for their prediction about the stock market, their response is more closely related to how the market recently performed than how it actually does in the future. That is, investors appear to guide themselves forward by looking into the rearview mirror. As a result, their forecasts tend to be overly optimistic in rising markets and overly pessimistic in falling markets.
Lastly, representative bias is related to the gambler’s fallacy. This fallacy is the tendency to put more importance on recent events rather than the long-term outcomes. Consider the roll of dice. A dice has six numbered sides. If, after 10 roles, the number 4 has not appeared, then someone suffering from gambler’s fallacy is likely to believe that the number 4 is now more likely to appear. But each number has a 1 in 6 chance of appearing no matter its recent pattern. So, acting on the belief that a 4 has a greater chance of appearing would lead to failure. The gambler’s fallacy is a form of the representativeness bias because it assumes recent observations of a process provide important information for what to expect in the future. But this belief isn’t always true. The problem with the representativeness heuristic is that similarity in one aspect doesn’t necessarily lead to similarity in other aspects.
A popular Wall Street proverb is “invest in what you know.” Because you can choose from thousands of stocks and mutual funds, the choices can be overwhelming. To narrow down the choices, you may rely on familiar companies. Finding well-known investments feels comfortable. However, when you get too comfortable, you’re likely to underestimate your risks. Familiarity bias occurs when investors prefer familiar investments over unfamiliar assets that have better investment characteristics. For example, investors overweight their portfolio with local firms (local bias) that operate nearby. When investors own the stock of an electric utility, they usually own the utility that services their hometown. It’s the most familiar one. Investors also prefer firms from their own domestic market (home bias) rather than firms from foreign markets. That is, US investors own stocks of mostly US firms, while Japanese investors own primarily Japanese stocks. Investors in both the United States and Japan could lower their risks by diversifying in the other marketplace.
A potentially damaging familiarity bias facing investors is overinvesting in an employer’s stock. Many employees have a defined contribution plan at work, like a 401(k) plan. They can invest their pension money in mutual funds and often their company’s stock. Because employees are well-acquainted with their company, they often believe that their firm’s stock has a low-risk level. Studies show that two-thirds of employees believe their company’s stock is as safe or a safer investment than an S&P 500 Index fund. However, no company is safer than a diversified portfolio of the largest 500 US companies. Diversification lowers risk. Due to familiarity bias, these employees underestimate the risk of investing in their company’s stock. The risk is real. Just ask the employees of companies that have gone bankrupt. When bankruptcy occurs, a company’s stock is wiped out. If you invested much of your pension money in company stock and were an employee at Sears, Radio Shack, Toys ‘R’ Us, Circuit City, or other companies that have filed for bankruptcy, then you would have lost that pension investment and might even have been laid off. You should diversify your pension investments away from your employer’s stock to reduce this risk.
To overcome familiarity bias, you need to think about the positive characteristics of diversification. To increase diversification, you should include the unfamiliar. Consider portfolio allocation to international markets and non-local firms to gain wider diversification and risk reduction.
Decision frames are the forms in which a question is proposed. A change in the frame can elicit a different response. In other words, you can be fooled by how a question is asked. Nobel Laureate Daniel Kahneman provides a simple example of frame dependence. He gives the following math problem to participants and asks them to estimate the answer within 10 seconds:
2 × 3 × 4 × 5 × 6 × 7 × 8.
A different group receives the same math problem, but in a different frame:
8 × 7 × 6 × 5 × 4 × 3 × 2.
In the first frame, the average estimate was 512. In the second frame, the average was about four times higher or 2,250. A huge difference in the responses occurs by reversing the order of the numbers – starting with 2 instead of 8. The decision frame can influence your judgment. Note that people aren’t very good at estimating math problems; the answer is 40,320.
How do you expect the stock market will perform next year? Your answer could involve a return or a level. For example, if your favorite stock index is at 3,000, you could say that you expect the index to be at 3,300 at the end of the year. Or, you could say you expect a 10% return. Returns and levels are two different ways to frame the same information. These frames have different influences on predictions though. Forecasting levels causes lower predictions than forecasting returns. Due to this bias, the index example above might be predicted to be only 3,250, which implies only an 8.3% return. This result happens because in forecasting levels, people tend to reverse or slow the current trend. When using percentages, they often extrapolate the trend. Thus, the frame in which you think about the return characteristics of your portfolio or individual assets might create a bias.
Framing can substantially affect your investment choices and thus your wealth. For example, reviewing potential investment options individually as compared to together as a portfolio leads to less diversified selections. Investors suffer from this narrow framing because they only evaluate a few factors that may affect their investment, rather than looking at the whole picture.
Another example is the frame in which your pension plan is presented. The amount you contribute to your defined contribution plan and its asset allocation are the two most important decisions you make for growing your pension wealth. Yet, studies show that using a poorly designed decision frame can nudge you toward making a smaller contribution or even no contribution. Also, a poor frame can lead to poor investment choices with a lower portfolio expected return. Low pension contributions and low returns can cost you hundreds of thousands of dollars over several decades.
Lastly, people make different asset allocation decisions depending on how past returns are presented. For example, showing annual returns for many years leads to higher allocations to stocks compared with showing monthly returns. This occurs because monthly returns are more volatile. Given that asset allocation is a highly important determinant of the portfolio realized return, these decision frames can have lasting wealth impacts.
Related to the illusion of knowledge is the illusion of control. Illusion of control bias is the tendency to irrationally overestimate your degree of influence over external events. This illusion comes from the subconscious belief that by participating in an event, you have some control over the uncontrollable. A simple example is betting on the flip of a coin. You can flip the coin, hide the result, and then ask for bets. Or you can ask for bets and then flip the coin. More people will bet if the coin has not already been flipped. It’s like they believe their participation affects the coin’s rotation in the air. That subconscious belief of control is an illusion. The belief also shows up when people focus their attention on a stock or other investment.
What do you control? You have control over your asset allocation, security selection, and market timing. You don’t have control over the outcomes from these decisions. If you’re subject to the illusion of control, you may experience excessive trading and its associated costs as well as under-diversified portfolios. Studies also show that the more you think you’re in control, the worse your actual performance.
Information that’s easy to recall and understand is used more often in cognitive processes than information that’s less available. Availability bias is the tendency to give a greater weight to easily recalled information. The problem is that while this available information may be considered more important within the brain, it might actually be less important to the decisions at hand. In other words, this bias prevents you from considering other potential and relevant information. The most available information tends to be from entertaining sources in the media or from advertising. All that glitters isn’t gold. Investors succumbing to the availability bias may be attracted to the most advertised mutual funds, hot stock tips, and recent winners. Unfortunately, those are usually poor investment choices for the future. Availability bias can lead to concentrated portfolios, increased risk, and buying high and selling low. When researching investment ideas, try to conduct a more thorough analysis that uses deeper information and knowledge. Also, examine whether investment possibilities meet your portfolio needs and goals.
Cognitive dissonance is the mental uneasiness resulting from inconsistent thoughts and beliefs. The dissonance leads to the alteration in one of those conflicting attitudes. You believe that you’re a good investor, but your portfolio return neither performed well nor beat the market index. Your brain feels uncomfortable with these two contradictory ideas. To reduce this psychological pain, you can:
Ignore or minimize one of the ideas, like ignoring the poor performance.
Change one or both ideas, like misremembering that the performance was good.
Add a third idea to attenuate the dissonance, like remembering that you were following an advisor’s advice.
Studies show that one common resolution of cognitive dissonance is for people to misremember their actual investment performance. That is, they remember that their portfolios earned higher rates of return in the past than they really did. Another common resolution is to blame others. For example, if your mutual fund underperforms, you’re likely to blame the mutual fund manager instead of yourself for picking that fund. Cognitive dissonance makes identifying and remedying your mistakes difficult.
Several problems can arise from cognitive dissonance. You may fail to make decisions because it’s too difficult to thoroughly understand the situation. Also, when the brain filters information so that beliefs can be consistent, you might miss important news or facts that are relevant to your investing decisions. Lastly, you may not take any action to improve your own knowledge and skills.
You learn through watching and interacting with others to infer their beliefs and ideas. Talking is an important mechanism for assessing your ideas and forming your opinions. Thus, your family, friends, and colleagues can influence your behavior. This fact is especially true for investing. For example, someone’s interest in a stock often results from another person mentioning it. Being influenced by the social norms of your social group is called social bias. The more social you are, the more likely you’ll invest in the stock market. Why? You’re likely to become more comfortable with the dynamics of investing through conversations. Studies show many different groups influence your investing decisions:
Your friend’s enthusiasm or lack of it for a stock influences how much stock you buy.
Your portfolio choices are often similar to the holdings of your close associates.
The pension choices of your colleagues may influence your participation in and allocation to a pension plan at work.
In summary, your social circle has an important influence on your investment decisions, so choose your friends wisely.
One type of social bias is herd behavior, which occurs when people mimic the buying and selling actions of a larger group, especially during times of high uncertainty. Here’s a non-investment example of following the pack. Wildebeest travel in herds for protection. Each individual wildebeest doesn’t have to see the danger, it just has to run when the others run. Similarly, by watching what other investors are doing, you may try to reduce your exposure to investment danger. As a result, some people are attracted to the same stocks or mutual funds that others are buying. Following the pack occurs for several reasons:
You may feel social pressure to follow the social norm of your social group.
It’s easier to skip doing analysis and just follow the herd.
You don’t want to be left out of what everyone is talking about. This phenomenon is called “fear of missing out.”
But engaging in herding behavior isn’t necessarily a profitable strategy. Since many investors follow others without doing their own analysis, a group-think mentality occurs. Thus, the herd’s buying or selling can become irrational. Trying to follow the herd has its problems:
As part of the herd, you may ignore conflicting information about an investment.
You may believe that others in the herd know more than they do, especially if you are a novice investor.
Moving with the herd magnifies psychological biases because it’s based on the “feel” of the herd.
Following the herd can lead to buying high. By the time you see what everyone else is buying, others have likely already bid up the price.
Selling can happen quickly. When animal herds flee, they do so very suddenly. If you aren’t paying attention, you’ll be at the back of the pack. By the time you notice, the selling may have already pushed the price lower.
Herding contributes to stock market bubbles and crashes when irrational investors push prices beyond their fundamental values.
A common Wall Street adage is that investors are ruled by fear and greed. Although this saying is a greatly simplified characterization of reality, it addresses an essential truth – emotions can influence your decisions. You might think that people would be more rational because money is involved, but research shows the opposite. Why? The brain can’t function like a computer and has cognitive limitations. People routinely must make decisions without having all information desired. To make a decision under uncertainty, the brain’s analytical side must work with its emotional side. The emotional side helps to bridge the information gaps. Thus, you need emotions to help make many investment decisions because they involve much uncertainty. Unfortunately, decisions that benefit you over the long term are usually made in low emotion environments. Thus, while you need the emotional side of your brain to make some decisions, it’s best to minimize the impact of those emotions. Scholars refer to emotions as feelings, also called affect, and moods.
The failure to manage feelings and moods helps to explain why many investors fail to earn suitable returns over time. A study that records investor trades and self-reported emotional states illustrates this situation. The investors who reported the most intense emotional response to gains and losses exhibited much worse trading performance.
Even background mood can influence financial decisions, called misattribution bias. You can misattribute the mood you feel to be related to the financial decision to be made. If you’re in a good mood after taking a walk during a beautiful, sunny day, you’re more likely to be positive about an investment. This feeling has little to do with the investment itself and is mostly about the background mood. A good mood increases the likelihood of investing in high-risk assets because positive feelings can lead to underappreciating the risks. Negative moods also affect decisions. You can be in a negative mood for reasons completely unrelated to the investment analysis being made, like having your favorite sports team lose. Yet, that bad mood makes you more critical and analytical in a decision. Interestingly, being in a bad mood can lead to better-investing decisions.
Being optimistic skews your belief about the chance of bad things occurring. By underestimating the probability of a bad outcome, you’re more likely to take unnecessary risks. Optimistic investors also tend to ignore new information that challenges their positive beliefs. Similarly, an optimistic investor may discount or downplay negative information and be less critical when analyzing an investment opportunity. In other words, when negative news about the firm is revealed, the optimistic investor, looking through rose-colored glasses, holds fast to the belief that a firm is great.
A high level of investor optimism can affect stock prices. If there’s a balance of optimistic and pessimistic investors, then optimists will drive the stock price. Pessimistic investors stay on the sideline, while the optimists buy, thus setting the price by bidding it up. As the price rises, pessimists might become even more pessimistic about the stock being overvalued. Staying on the sideline and not trading doesn’t affect the price. Most stocks are priced by non-emotionally biased investors. But those stocks with a large degree of uncertainty about their prospects tend to have a higher proportion of optimistic and pessimistic investors following them. These stocks often represent newer companies because large, well-established firms have less uncertainty about their prospects due to having more information available about them. For example, General Motors, Procter & Gamble, and Intel are well-known companies with little room for a high degree of optimism and pessimism. Firms in industries with new technologies are especially susceptible to optimistic pricing. After the uncertainty in these firms is resolved, unbiased investors set the price. This resolution can include a decline in the stock price.
Exaggerated optimism might be called irrational exuberance. According to Nobel Laureate Robert Shiller, irrational exuberance is the psychological basis of speculative bubbles. In a speculative bubble, the news of a rising stock price spurs investor enthusiasm, which spreads from person to person. This process amplifies the stories that investors use to justify the increasing price and leaves behind any negative information. Eventually, a herd of growing irrationally optimistic investors continues to drive up prices despite the doubts of pessimists. A type of gambler’s excitement can occur. But speculative bubbles are, by their nature, a transient social phenomenon. At some point, the last optimistic investor buys the stock. Without the herd buying, the price starts to fall. Then panic sets in as optimism fades. When a speculative bubble ends, it does so with a crash.
Many examples of speculative bubbles are available such as Bitcoin, the most well-known of the cryptocurrencies. It closed on July 15, 2017 at $1,914. Bitcoin peaked about five months later, on December 17, 2017 at $19,891 for an historic 939% return. It then lost 44% of its value by declining to $11,163 over the next month. One year later, the price of Bitcoin was only $3,548, a total decline of 82%.
Another example is the tech bubble of the 1990s, which saw the NASDAQ-100 Index rise from 125 on January 31, 1985 to 4,816.35 on March 24, 2000. This rise represented a 3,753% return during the 15¼ year period. One year later, the NASDAQ-100 had lost nearly 65% of that value. “Dotcom” firms, companies with “.com” in their names, did even worse during the crash. The United States experienced a real estate bubble between 2007 and 2009, an oil bubble in 2008, a gold bubble in 2011, and stock market crashes in 1929 and 1987. Although these are market examples, numerous examples of single stock manias are available.
Savvy financial decisions are based on conducting a solid analysis and viewing investment opportunities with a critical eye. Getting caught up in optimistic behavior, especially irrationally exuberance, usually ends badly.
Investors often behave irrationally. But people aren’t computers and thus the standard of rationality is likely too high. Instead, people are normal. Normal people display behavioral biases when making investing decisions that can negatively affect their wealth, sometimes in severe ways. Savvy investors try to avoid succumbing to self-inflicted pitfalls as much as possible. Here are some takeaways from the chapter:
Take your losses to gain tax advantages and invest in better assets.
Be aware that regret aversion negatively affects your portfolio holdings.
Use rules of thumb to boost your willpower and self-control.
Avoid the problems of excessive trading and taking too much risk associated with overconfidence.
Be wary of using representativeness bias in your decision making. Good companies aren’t always good investments and past returns don’t necessarily indicate future returns.
Remember that familiarity leads to underestimating risks and overestimating performance.
Don’t fall for the influences of decision frames as they can nudge your cognitive processes toward sub-optimal judgments.
Control your investment choices and don’t be tricked into thinking you control the outcome.
Don’t rely only on the most recent information but instead evaluate a fuller picture of the investment to avoid availability bias.
Record and evaluate your investment performance to avoid being influenced by cognitive dissonance.
Realize that your friends are likely to influence your investment choices.
Avoid investing with the herd. If you’re one of the last to buy and sell, you’ll buy high and sell low.
Don’t make investment decisions based on greed, fear, and other emotions.
Know that optimistic investors can make poor choices because they conduct analysis through rose-colored glasses revealing an optimistic picture but hiding the truth.