Investing Driving You Crazy? Maybe Its Because You Already Are! (Part 3)

Investing Driving You Crazy?  Maybe Its Because You Already Are! (Part 3)

In Part 3 of this series, we discussed the final cognitive biases, namely overconfidence, selective memory and mental accounting. Remember, cognitive biases are biases or errors that are based on empirical factual knowledge. In this article we will discuss and provide examples of some emotional biases (continued in Part 5). Emotional biases originate from impulsive feelings or intuition (as opposed to conscious reasoning) and are thusly much more difficult to correct. Notice that many of these biases/errors are overlapping.

Fear-of-regret, or simply regret, deals with the emotional reaction people experience after realizing they've made an error in judgment. We all have a tendency to fell the pain of regret for having made errors, even small errors. In order to avoid facing this pain we alter our behavior, in many cases in a manner that is completely irrational. For example, faced with the prospect of selling a stock (or mutual fund), investors become emotionally affected by the price at which they purchased the stock. They avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. After all, we all hate to be wrong, don't we?

What investors should really ask themselves when contemplating selling a stock (or mutual fund) is, "What are the consequences of repeating the same purchase? If this security were already liquidated (or I had never purchased it) and would I invest in it again?" If the answer is "no", it's time to sell. If you don't, it is because of the regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made - and a vicious cycle ensues where avoiding regret leads to more regret.

Regret theory can also hold true for investors who find a stock they had considered buying but did not went up in value. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision with "everyone else is doing it". This is called herding or groupthink, which we will touch on later. Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns (like AOL and Yahoo in 2000) than about losing on an unknown or unpopular stock. In reality, the same holds true for mutual fund managers and is one reason why (of many, including attracting your money as an investor) many managers are simply ?benchmark huggers? (i.e. their holdings almost mirror well known benchmarks). The pain of stepping out and being wrong is too great.

Lack of Self-Control
Self control means controlling emotions. There is not much to say in regards to self ?control, as it is fairly self-explanatory. Not being able to control your emotions with regards to investing is a huge impediment to being successful. Emotional investing will destroy you.

Loss Aversion
People tend to be much more distressed about a loss than they are happy about the same amount of gain (speaking in terms of dollars). Some researchers have concluded investors typically consider the loss of $1 twice as painful as the pleasure received from the gain of $1. As a result, investors are willing to take more risks to avoid the pain of a loss than to ensure the pleasure of a gain. Faced with a sure gain, most investors are risk-averse. But faced with a sure loss, investors tend to become risk takers. Here is a perfect example:

Daniel Kahneman and Amos Tversky presented two groups of subjects with two different problems. The first group was given $1,000 and asked to choose either a sure gain of $500, or a 50% chance to gain $1,000 and a 50% chance to gain nothing. The second group was given $1,000 and asked to choose either a sure loss of $500, or a 50% chance to lose $1,000 and a 50% chance to lose nothing. In the first group, 84% chose the sure gain of $500, while in the second group, only 31% chose the sure loss of $500. While the two problems offered basically the same net cash, the framing of the question caused the offers to be interpreted quite differently. (For more information, see "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.)

Another term for hindsight biases is Monday morning quarterbacking. According to Robert Shiller (2000) ?The reason for overconfidence may also have to do with hindsight bias, a tendency to think that one would have known actual events were coming before they happened, had one been present then or had reason to pay attention. Hindsight bias encourages a view of the world as more predictable than it really is.? Further, a hindsight bias is an inclination to see past events as being predictable and reasonable to expect, perhaps because they are more available than possible outcomes that did not occur. Subjects also tend to remember their own future predictions as being more accurate than they were after the fact. People are, in effect, biased by the knowledge of what has actually happened when evaluating its likelihood. This is also known as the `I-knew-it-all-along? effect, reflecting a common response to surprise. Hindsight bias can be reduced when people stop to think carefully about the causes of the surprise. It is also important to consider how other things might have happened.