Bogleheads® Wiki 2016 annual report

Wise investing is based on an asset allocation appropriate for your financial capacity, but ultimately on your emotional capacity for risk, also known as risk tolerance. If you’re not aware of your emotions or how they affect your financial decision-making, you are likely to take on too much risk and then panic and fail to stay the course during down markets or market crashes.

“Your investing brain does not just add and multiply and estimate and evaluate,” says Jason Zweig in his book, Your Money and Your Brain. “When you win, lose, or risk money, you stir up some of the most profound emotions a human being can ever feel.”

“Financial decision-making,” says psychologist Daniel Kahneman in Zweig’s book, “is not necessarily about money. It’s also about intangible motives like avoiding regret or achieving pride.”

In the 1960's, Daniel Kahneman, a Nobel Laureate, and Amos Tversky pioneered a field that became known as behavioral economics. The pair performed experiments that showed people don’t always make rational choices in their own best interests. They then organized and classified rules-of-thumb people used to make quick economic decisions and named them judgmental heuristics, most of them are more emotional than rational.

Awareness of the most common behavioral pitfalls, such as overconfidence, loss aversion, and risk aversion, can help you understand, control, or possibly avoid them. And when it’s time to invest based on the Bogleheads® investment philosophy, it can help you develop an asset allocation that is appropriate for your risk level and that helps you stay the course.

Heuristics
The process by which investors make decisions for themselves often involving trial and error.

Representativeness
Incorrectly judging the likelihood of an event based upon how similar event A is from event B.

Overconfidence
Usually the common tendency to attribute investment success to individual performance rather than market performance.

Anchoring
The tendency to reason based on a specific bit of information (the "anchor"), often the first information obtained, or information of a personal nature. Attaching special significance to the price at which an asset was purchased, or its recent high, are examples of anchoring. Anchoring may have caused many to not perceive increased risks in the U.S. housing market because the data focus was on recent price increases and sales rather than the decreasing quality of loans.

Recency Bias
The tendency to draw conclusions about the future behavior of an investment from only the recent past. A typical expression of recency bias heard during an asset bubble is "this time it's different".

Availability Bias
The tendency to rely on information that is readily obtained or recalled rather than seeking unbiased sources and complete information. For example, information on price increases and sales in the U.S. housing market was much more available than data on the decreasing quality of loans. Similarly, those who purchase individual stocks tend to talk more about their winners than their losers, leading to a perception that amateurs can consistently "beat the market". The same applies to mutual fund companies advertising winning funds while silently closing losers (see also "survivorship bias").

Gambler's Fallacy
The tendency to believe the odds of an event change based on prior outcomes. For example, if you flip a coin five times and it comes up heads, it is the tendency to believe there is a greater than 50/50 chance the next flip will be tails, even though the odds are still 50/50. For investing, the stock market increases for five months in a row and the investor believes there is a greater chance the market will decline in the sixth month based upon the results of the previous five.

Paralysis by analysis
Paralysis by analysis refers to a behavior that an investor doesn't do anything because he is overwhelmed with information.

For example, an investor may wonder whether he should go with Traditional IRA or Roth IRA. He might wonder forever and eventually end up not contributing at all to either account.

Confirmation bias
Confirmation bias in investing is the tendency to look for evidence that justifies the purchase or sell decision by the investor after-the-fact. Only information supporting the investor decision is accepted and evidence to the contrary is ignored or minimized.

Prospect Theory
The investor tendency to misunderstand risk versus reward. For example, if an investment is first presented emphasizing a 10% expected return, then the same investment is presented this time emphasizing the potential of a 10% loss, the investor may change decisions even though risk versus reward information was not changed. Other ways prospect theory appears include loss aversion, regret aversion, mental accounting and self control.

Loss aversion
The tendency to seek risk when faced with the prospect of loss and avoid risk when faced with the prospects of enjoying gains.

Regret aversion
The tendency to avoid realizing a loss. This causes investors anchored on their purchase price to "hold losers" relative to "selling winners."

Mental accounting
Mental accounting refers to behaviors relating to how an individual frames decisions regarding the receipt and dispersing of money.

For example, if an investor gets a tax return from the IRS, he might spend it as if it were some found money even though the amount was an interest-free loan to the IRS.

As another example, an investor who inherits individual stocks from a close relative may have emotional attachment to those stocks even though he may be able to improve the risk adjusted return of his portfolio by selling the stocks and diversifying the proceeds.

Self control
Using separation of accounts to control behavior, such as starting a savings account to save for a new car. The future purpose of the funds takes precedence over the investment choice.