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Behavioral Finance and Decision Making Biases

Contributed by mm | July 15, 2005 5:52 AM PST

One of the best trainings I've ever attended at Microsoft is Avoiding Common Thinking Traps. It is about how we think, and the common mistakes in decision making processes. For example, many of us usually based our decisions on recent events ("this process worked for us last time, and it will work again") or wishful thinking ("I know we will succeed"). While I still cannot avoid some of these mistakes, at the very least, I can catch on most before any damage.

Today, I ran into a great article on behavioral finance at Investment Advisor that discussed how these thinking traps affect our personal finance decisions. While the article is written for financial advisors (on how to manage their customers), the accompanying list of these common "cognitive errors" is a great read. (I added the examples at the end of each bullet.)

Anchoring. The tendency of investors to become attached to a specific price as the fair value of a holding. ("I bought the stock at $150, so I will never sell it below this price.")

Attachment bias. Holding onto an investment for emotional reasons, such as “my grandfather left me this stock.”

Cognitive dissonance. The challenge of reconciling two opposing beliefs, which often results in remembering the positive parts of an experience but forgetting the negative. ("I made a lot of money in stock A, B, C" -- while he lost more in D, E and F.)

Confirmation bias. The natural human tendency to accept any information that confirms our preconceived position or opinion and to disregard any information that doesn’t support that preconceived notion. ("Today's WSJ story confirms my belief that NASDAQ will see 5,000 very soon.")

Fear of regret. The tendency to take no action rather than risk making the wrong one, which often causes an investor to hold onto a stock that’s losing value, because if they sold and it rebounded they’d feel even worse. ("I don't think I should sell my house. What if the home price continues to go up?")

Hindsight bias. The 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not. ("Now that I've witnessed the 2000 bubble, I will never lose money in another bubble again.")

Inappropriate extrapolation. The tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely. ("See, Google stock price more than tripled in last year. Buy the stock now and you can earn another 200% in no time.")

Mental accounting. This entails looking at sums of money differently, depending on their source or the intended use. ("Honey, this is the free money of tax refund. Let's plan a trip to Hawaii.")

Outcome bias. The tendency to make a decision based on the desired outcome rather than on the probability of that outcome. ("I think my investment will pay off handsomely because if so, I can retire in 5 years.")

Overconfidence. This is the tendency to place too much emphasis on one’s own abilities. It often works hand in hand with confirmation bias. ("I am smart enough to beat the index in the stock market.")

Prospect theory. Originally developed by Daniel Kahneman and Amos Tversky, it describes the different ways people evaluate losses and gains. Their research found that losses have a much greater negative impact than a commensurate gain will have positive. ("I will never play this stock again even I know it is cheap. I lost dearly last year.")

Self-affirmation bias. The belief that when something goes right, it’s because you were smart and made the right decision. If it doesn’t work out, it’s due to someone else’s fault or simply bad luck. ("Look at how smart I am: stock A earned 200% for me in one month. ... Don't mention stock B. I cannot foresee the bankruptcy and it is totally management's fault.")

Status quo bias. The tendency of investors to do nothing when action is actually called for. ("I know the investment is risky, but I don't think I'm prepared to sell it.")

Did you learn a lesson or two from these?

More PFBlog Articles You Might Find Interesting ...

This Post Has Received 2 Comments. Share Your Opinions Too.

Michael Commented on July 15, 2005

If you're interested in behavioral finance, then you might enjoy reading WHY SMART PEOPLE MAKE BIG MONEY MISTAKES, by Belsky and Gilovich. There are quite a few books on this topic, but this one is easily the most readable.

Marie O Commented on July 17, 2005

Congratulations, just read about you again in the Wall Street Journal Sunday section of the local paper.

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