The Psychology Behind Common Investor Mistakes

From R. Douglas Van Eaton, CFA, professor of finance in the
College of Business Administration at the University of North Texas, discusses common investor errors:

Overconfidence

Fear of regret/pain of regret

Cognitive dissonance

Anchoring

Representativeness

Myopic risk aversion

Van Eaton notes" A better understanding of the psychology of investor mistakes can
reduce their effects on investment decisions. Here is a list of the
most common psychological effects, and how you can reduce their impact
and incorporate them into your own investment decisions."

The full piece is below.

>

Source:
The Psychology Behind Common Investor Mistakes
R. Douglas Van Eaton
AAII Journal
http://www.aaii.com/promo/evergreen/basics/jrnl200004p02.cfm

Complete piece:

>

"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.

By combining psychology and finance, researchers hope to better
explain certain features of securities markets and investor behavior
that appear irrational. Standard finance models assume that investors
are unbiased and quite well informed. Investors are assumed to behave
like Mr. Spock from Star Trek, taking in information, calculating
probabilities and making the logically "correct" decision, given their
preferences for risk and return. Behavioral finance introduces the
possibility of less-than-perfectly-rational behavior caused by common
psychological traits and mental mistakes.

Six common errors of perception and judgment, as identified by
psychologists, are examined in this article. Each has implications for
investment decision-making and investor behavior. An understanding of
the psychological basis for these errors may help you avoid them and
improve investment results. And in some cases, market-wide errors in
perception or judgment can lead to pricing errors that individuals can
exploit. Understanding the psychological basis for the success of
momentum and contrarian strategies can help investors fine-tune these
strategies to better exploit the opportunities that collective mental
mistakes create.

Overconfidence

A good starting point for a list of psychological factors that
affect decision-making is overconfidence. One form is overconfidence in
our own abilities. A great number of psychological studies have
demonstrated that test subjects regularly overestimate their abilities,
especially relative to others. Studies also show that people tend to
overestimate the accuracy of information. With respect to factual
information, research subjects consistently overestimated the
probability that their answer to a question was correct.

You might expect that professional stock analysts are less prone to
psychological biases than non-professional investors and the general
public. With regard to overconfidence, however, this is not the case. 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.

How does overconfidence affect investment behavior?

Models of financial markets with overconfident investors predict
that trading will be excessive. One recent study used a creative
approach to see if overconfidence is related to high levels of trading.
Many psychological studies have shown that men are more prone to
overconfidence than women. If overconfidence causes overtrading, then
men should exhibit their greater tendency toward overconfidence by
trading more. The results of the study show exactly that-for a large
sample of households, men traded 45% more than women, and single men
traded 67% more than single women over the period of the study.

Is the active trading that overconfidence leads to actually
‘excessive,’ causing lower performance? A study of the trading activity
and returns for a large national discount brokerage suggests that it
is. For all of the households, returns averaged 16.4% over the period.
However, those that traded the most averaged 11.4% in annual returns,
significantly less than for an account with average turnover. Over the
same period, the S&P 500 returned 17.9% on average.

What, if anything, can investors do about the general tendency toward overconfidence?

You can profit from this research only by heeding its message: Trade
less. This is perhaps more easily said than done. Placing too much
confidence in an analyst’s buy/sell recommendation or earnings
projection may lead to excessive trading even without any illusions
about your own stock-picking abilities.

Other aspects of overconfidence are more subtle. People prefer to
bet on the flip of a coin if it has not already been tossed.
Psychologists relate this to a tendency for people to believe that they
either have some ability to foretell the future or some control over
the outcomes of future events.

Another behavior that is related to overconfidence in our abilities
is the tendency to treat historical information as irrelevant and to
place much more importance on current circumstances as a determinant of
future outcomes. The psychological basis for such a tendency is called
"historical determinism," the belief that historical events could or
should have been predictable given the circumstances of the past. For
investors, this translates to a belief that market events, such as the
1929 crash, could not have developed any other way. Only if we
determine that current circumstances mirror those of some past time
period will we be inclined to give history its due. Our collective
social memory may tend to emphasize things that are seen as directly
causing past events, and exclude circumstances that suggest a different
outcome. The cry of "this time it’s different" has a special place in
investment lore. It is perilous to ignore stock market history based on
a belief that present circumstances make historical market performance
irrelevant to current decisions.

Fear of Regret

A second mental error that can affect decision-making is an
excessive focus on the potential feelings of regret at having made a
poor decision (or a ‘good’ decision that turns out poorly). This type
of error is rooted in most individuals’ (sometimes extreme) dislike for
admitting they are wrong. The tendency to feel distress at having made
a mistake that is out of proportion to the size and nature of the error
is what psychologists label the "pain of regret." The fear of regret
manifests itself when the potential regret from making an error has an
influence on our decision-making that is out of proportion to the
actual penalty an error would impose. Some behavioral models are
constructed around the idea that people make decisions so as to
minimize the potential regret that may result.

The fear of regret influences behavior when individuals
procrastinate in making decisions. 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 (called the disjunction effect by psychologists).

The fear of regret can play an important role in our investment
decision-making in other ways as well. 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. When stocks go down in value,
investors seem to delay the selling of those stocks, even though they
likely have not met expectations. Selling the position would finalize
the error and the pain of regret is delayed by not accepting the
purchase as an error. Winning stocks, on the other hand, contain the
seeds of regret. The sale of appreciated shares removes the possibility
that those shares will fall in value along with the potential for
regret should this occur before the shares are sold. Besides avoiding
poor decisions from too much focus on the fear of regret, you may also
be able to improve performance by exploiting pricing patterns that
result from behavior rooted in the fear of regret. A general tendency
among investors to hold on to losers too long will slow the price
declines, since less shares are offered for sale. Similarly, a tendency
to sell winners too soon will increase the number of shares for sale
and slow price increases. Both of these effects can enhance
opportunities for investors.

Strategies based on price momentum and earnings momentum seek to
exploit the fact that price changes occur slowly, over a sometimes
prolonged period of time. Studies show that stocks that have performed
the best (or worst) over six months to a year are likely to remain good
(or poor) performers over the next year. There has been considerable
research over the years showing that firms that announce surprisingly
good (or poor) quarterly earnings tend to outperform (or underperform)
for up to a year after the earnings announcement.

While the success of momentum strategies may also be a result of
other psychologically driven behaviors, a tendency to sell winners too
soon and losers too late will, in general, make price adjustments to a
new equilibrium level a more drawn-out process than it would otherwise
be. Investors can purchase stocks of firms that are in an established
uptrend, with both earnings and price momentum, and hold them until the
trend has reversed. For stocks that show a negative trend in earnings
and price, the message here is: Get out. The deterioration will likely
be longer and more severe than you think. Such discipline should reduce
the tendency to sell winners too soon and hold losers too long, and
improve investment results.

Cognitive Dissonance

A psychological characteristic that is related to the fear of regret
is the desire to avoid cognitive dissonance. This psychological trait
is one you might remember from Psychology 101. Without the jargon, the
reference is to a desire to avoid believing two conflicting things. If
one of the beliefs is supported by emotional involvement or attachment,
the brain will attempt to avoid or discount a conflicting belief and
seek out support for the preferred belief.

In the classic study of this characteristic, researchers found that
once a person had made a decision and purchased a particular
automobile, they would avoid ads for competing models and seek out ads
for the model purchased. Avoiding the pain of regret may be the basis
for this behavior. One way to avoid regretting the purchase decision is
to (irrationally) filter the information received (or believed) after
the decision has been made. Alternatively, people can minimize the
importance of subsequent information that would call their original
decision into question, if the truth can’t be avoided or denied.
Beliefs that we wish to maintain are defended by many mechanisms, even
if the strong desire to maintain existing beliefs has a
less-than-rational basis.

How can you adjust for the tendency to avoid or deny new,
conflicting information? As in other areas, investment discipline can
help. By writing down the reasons for purchasing a stock and
re-evaluating their validity over time as dispassionately as possible,
investors can force themselves to maintain a selling discipline. If the
reasons for purchase no longer hold and the share price indicates
deteriorating fundamentals, admitting a mistake may often be the
prudent thing to do. Another disciplined approach is to set a time
limit for a newly purchased stock to perform as expected. If, for
example, the earnings and/or price expectations have not been met after
three months, then the stock must go. While this is not necessarily a
good rule for value investors (since that approach often requires
longer holding periods before expectations are met), it can help those
who pursue a growth strategy to avoid holding losing positions over a
prolonged period of price deterioration.

Anchoring

The three psychological characteristics discussed so far are all
based, to some extent, on feelings and emotions. But some
decision-making errors result from mental shortcuts that are a normal
part of the way we think. The brain uses mental shortcuts to simplify
the very complex tasks of information processing and decision-making.
Anchoring is the psychologists’ term for one shortcut the brain uses.
The brain approaches complex problems by selecting an initial reference
point (the anchor) and making small changes as additional information
is received and processed. This reduces a complex problem, evaluating
all information as a whole as new information is received, to the
simpler task of revising conclusions as each new bit of information is
received.

In the case of bargaining, a salesman may begin with a high price to
bias upward the final price. Research shows that the listing prices for
homes influence estimates of their values. The listing price apparently
serves as an anchor, even though it does not necessarily contain
relevant information about the home’s value. Recent prices or recent
earnings performance may serve as a similar psychological anchor for
investors, and may have predictable effects on subsequent returns.

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.

The old pros say, "Don’t bottom fish," but they also say "Buy on
weakness." What’s the difference? If you have evaluated a stock and
determined that you would like to accumulate a position, then you can
and should time your buys to take advantage of the ebbs and flows in
the market and price weakness in the stock when it goes below your buy
price. If, on the other hand, a sharp price decline lies behind the
decision to buy and a recent higher price looms large in the stock’s
initial attraction, beware—the odds are against you.

One effect of anchoring on investment decisions is similar to that
of the fear of regret; losing positions will be held too long and
improving stocks will be sold too soon. In each case the effect of a
recent price as a psychological anchor in the complex process of stock
valuation will slow the revision of valuation estimates. Losers will
appear cheap and winners will seem to have gotten ahead of themselves.
As with the fear of regret, anchoring can slow the process of
revaluation and contribute to the gains from momentum strategies. In
general, the less clear the underpinnings of a stock’s value, the
greater the importance of an anchor in the process of establishing
value. The valuations of highly speculative stocks, such as Internet
high flyers without visible earnings, will likely be more influenced by
recent prices, than those of stocks with visible and predictable
earnings.

Representativeness

Another shortcut that the brain uses to reduce the complexity of
thought is called representativeness by psychologists. This is an
assumption the brain makes that things that share similar qualities are
quite alike. Classifications are made based on a limited number of
shared qualities.

One example of representativeness in our thinking is the tendency to
classify people as either "good" or "bad" based on some short list of
qualities. When we do this, we gain in simplicity and speed, but at the
expense of ignoring the much more complex reality of the situation.

The effect of representativeness in investment decisions can be seen
when certain shared qualities are used to classify stocks. Two
companies that report poor results may both be classified as poor
companies, with bad management and unexciting prospects. This may not
be true, however. A tendency to label stocks as either bad-to-own or
good-to-own based on a limited number of characteristics will lead to
errors when other relevant characteristics are not considered.

Representativeness may also be related to the tendency of stock
prices to reach extremes of valuation. If poor earnings and share price
performance has a stock branded as "bad," representativeness will tend
to delay the reclassification of the stock as one investors would like
to own. On the other hand, "good" stocks may continue to be classified
as such by investors well after the firm’s prospects for either
earnings or price appreciation have diminished significantly.

Contrarian or value strategies seek to exploit just such erroneous
classifications. If a firm has been classified by most investors as a
bad one and the stock as a loser, initial changes in the company’s
outlook may leave the classification in investors’ minds essentially
unchanged. This collective classification can lead to stocks being
unloved and underpriced. A value investor seeks to buy the stocks
others classify as "bad," ideally at the time when the greatest
majority holds this view. When fundamentals have started to deteriorate
but the majority of investors have not yet reclassified the stock in
their minds, it is often an ideal time to sell.

Myopic Risk Aversion

The term "myopic risk aversion" refers to the tendency of decision
makers to be shortsighted in their choices about gambles and other
activities that involve potential losses. Much research has examined
what types of gambles people will accept, the effects of how the
possible outcomes of the gamble are presented, and whether people make
consistent choices.

As an example of how these results can apply to investment
decision-making, consider an investor saving for retirement. Each
year’s investment in equities rather than a lower-risk alternative can
be viewed as a single gamble. Unlike casino gambling, however, the
expected payoff is positive, and the investor has the opportunity to
invest in equities over a period of many years.

Two leading researchers in behavioral finance have concluded that
investors in this situation tend to hold less than the optimal amount
of equities because they place too much emphasis on the potential loss
from a single year’s investment in equities. They term this
shortsightedness myopic risk aversion.

In one study, investors in a company retirement plan chose larger
equity allocations after they were shown the actual results of
investing in equities over many different 20-year periods. The research
suggests that if investors focus on the distribution of outcomes for
the whole period, they are more likely to make the correct decision."

>

Source:
The Psychology Behind Common Investor Mistakes
R. Douglas Van Eaton
AAII Journal
http://www.aaii.com/promo/evergreen/basics/jrnl200004p02.cfm