Behavioral pitfalls

The  page is divided into two sections. The first section introduces and defines the most common pitfalls. the second section introduces theory and background for those who want to expand their knowledge in the area of behavioral economics.

Introduction and definitions
“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.”

Understanding and avoiding behavioral pitfalls will ultimately have a greater impact on investing success than any other factor. Since emotions and subsequent behavioral pitfalls are frequently associated with miscalculating risk tolerance and asset allocation, the new investor should be aware of behavioral pitfalls before making asset allocation decisions.

“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.”

Common behavioral pitfalls
Being overconfident in your investing abilities can lead to big investing losses. A main reason is that, in the short run, the ups and downs of the stock market are random happenings. Such unpredictable variations mean that intelligence, skill, and knowledge give you no edge, and thinking they do can be “hazardous to your wealth.” “The only way to achieve everything you’re capable of is to accept what you are not capable of,” says Jason Zweig.
 * Overconfidence

Loss aversion is the emotional tendency to strongly prefer avoiding losses over acquiring gains. As an example, loss aversion implies that one who loses $100 will feel twice the emotional pain as another person will feel satisfaction from receiving $100. Common indications include checking your portfolio on an almost daily basis, selling funds before you intended to lock in profits, or selling when you didn't intend to in order to avoid further losses.
 * Loss aversion

A human instinct that causes individuals to mimic the actions of a larger group rather than decide independently based on their own information. For example, in a bull market, an investor joins the crowd to avoid being the only one to miss out; in a bear market, he gets out to avoid being the only one to lose. In both cases, he abandons his own reasoning and concludes the majority must be right. Herd investors often don’t have a sound investment plan and they listen to market noise.
 * Herd behavior

Basing decisions or estimates on events or values already known (the “anchor”), even though these facts may have no bearing on the actual event or value. Investors will tend to hang on to losing investments by waiting for the investment to break even at the price at which it was purchased. Thus, they anchor the value of their investment to the value it once had, and instead of selling it to realize the loss, they take on greater risk by holding it in the hopes it will go back up to its purchase price.
 * Anchoring

A tendency to seek information that confirms one’s existing opinions and overlook or ignore information that refutes them. For example, when researching an investment, an investor might inadvertently look for information that supports his or her beliefs and fail to see information that presents different ideas. The resulting one-sided view can result in a poor investment choice. “In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe,” says Wall Street Journal columnist Jason Zweig.
 * Confirmation bias

A belief that the probability of an outcome has changed when it actually has stayed the same. If a coin is flipped 10 times and lands on "heads" every time, a person employing gambler's fallacy thinks the probability of the coin landing on "heads" the 11th time will be very low. In fact, the probability of a coin being "heads" or "tails" is 50% every time the coin is flipped. The probability remains the same. Some investors may sell a stock because they don’t think it will continue to go up, while others may hold onto a declining stock thinking further declines are improbable.
 * Gamblers fallacy

The tendency to draw conclusions about the future behavior of an investment from only the recent past. This leads to investors chasing performance and then buying high and selling low. “When funds go on a streak of high returns, investors tend to get in right before the peak; then, when the hot streak goes cold, too many shareholders bail out at the bottom,” explains Jason Zweig
 * Recency bias

A theory that says people anticipate regret if they make a wrong choice, and take this anticipation into consideration when making decisions. Fear of regret can play a large role in dissuading or motivating someone to do something. In investing, the fear of regret can make investors either risk averse or motivate them to take greater risks. For example, suppose that an investor buys stock in a small growth company based only on a friend's recommendation. After six months, the stock falls to 50% of the purchase price, so the investor sells the stock at a loss. To avoid this regret in the future, the investor will not invest in anything his friend recommends until he has independently researched it first.
 * Regret aversion

The tendency for people to put their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. According to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviors. For example, people often have a special "money jar" or fund set aside for a vacation or a new home, while still carrying substantial credit card debt.
 * Mental accounting

Investors have thousands of funds to choose from plus an abundance of market “noise” telling them what they should do. The more choices they have the harder it is for them to choose one, making it more likely they won’t make a choice and will fail to invest. For example, employees pass up billions every year in free money offered by their employer’s matching retirement plans. They do this simply because they can’t decide which investment course to take.
 * Paralysis by analysis