Behavioral pitfalls

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
Anchoring is often referred to as recency bias, and the concept of anchoring is the tendency to focus on a specific bit of information. The value of new information tend to be overemphasized when relevant to stock prices. However, anchoring could also cause recent information to be ignored. 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.

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 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.