A post for the newbies out there

[BadBoyBenny]

This was plagarized from the psych forum. DaveByTheWay first got the article. I thought It would be a good read for some of the people on this boards so I'm cross posting without express written, or implied oral consent.

Slate.com right now has an article by Henry Blodget (the disgraced former tech analyst) on why people aren't as good at investing as they think they are. It discusses a number of psychological issues currently grouped together under the theme of 'behavioural finance'.



(Article Excerpt) Issues:

Self-attribution Bias: We attribute our successes to ourselves, and we blame our losses on others or bad luck. This hobbles us in two ways. First, we don't learn from our mistakes because we don't see them as mistakes. Second, we assume we are skilled or smart when we're just lucky.

The Gambler's Fallacy: We tend to believe, incorrectly, that if a flipped coin has come up heads three times in a row it is more likely come up tails next time. Similarly, just because a stock or market has gone up or down for a while doesn't mean it is more likely to go the other way soon.

Prospect Theory: We have an irrational tendency to sell our winners to lock in profits and keep our losers to avoid taking losses. This causes us to sell too early when the market is going up and too late when it is going down. We also feel the pain of loss more than the pleasure of gain and, therefore, blow out losing positions in panic when we should just hang on.

Conservatism Bias and Confirmatory Bias: Once we form opinions, we tend to overvalue information that reinforces them and undervalue information that undermines them (conservatism bias). We even tend to seek out supporting information (confirmatory bias). Thus, we irrationally cling to incorrect conclusions, and, to paraphrase Simon and Garfunkel, hear what we want to hear and disregard the rest.

Overoptimism: We tend to be overoptimistic and overconfident. According to James Montier, when students are asked whether they will perform in the top half of their class, an average of 80 percent say yes. This tendency makes it easier for part-time hobbyists to dismiss a century's worth of academic research showing that only a tiny fraction of full-time professionals can beat the market.

Outcome Bias: We tend to evaluate decisions based on outcomes instead of probabilities. Thus, we congratulate ourselves for stupid choices that happen to turn out well and vow to never again make smart choices that happen to turn out badly. Our errors get reinforced, and our wise decisions rejected.

Buffett's "Rearview Mirror": We base our expectations for the future on what has happened in the recent past. Thus, we are most bullish at the end of long bull markets, when we should be most bearish, and most bearish at the end of long bear markets, when we should be most bullish.

Hindsight Bias: When we reflect on the past, we imagine that we knew what was going to happen when we didn't. As James Montier puts it, "You didn't know it all along, you just think you did." This allows us to imagine, for example, that we knew that the tech boom of the late '90s was a bubble and that everyone who suggested otherwise was an idiot or crook. It also makes us overconfident about our ability to predict what will happen next.

[adios]

[ QUOTE ]
Self-attribution Bias: We attribute our successes to ourselves, and we blame our losses on others or bad luck....

[/ QUOTE ]

I'd put this succinctly as don't confuse brains with a bull market.

[ QUOTE ]
The Gambler's Fallacy: We tend to believe, incorrectly, that if a flipped coin has come up heads three times in a row it is more likely come up tails next time. Similarly, just because a stock or market has gone up or down for a while doesn't mean it is more likely to go the other way soon.

[/ QUOTE ]

Yep.



[ QUOTE ]
Prospect Theory: We have an irrational tendency to sell our winners to lock in profits and keep our losers to avoid taking losses.

[/ QUOTE ]

This can be solved in theory by assessing the value of a security as accurately as possible which isn't necessarily easy to do. How well can an individual predict future sales? It's possible if one has some in depth knowledge of the markets that a company serves.

Also fear is a factor to be considered IMO. I can't tell you how many times I've seen some sort of unwarranted sell off drive prices to ridiculous levels.

[ QUOTE ]
Conservatism Bias and Confirmatory Bias: Once we form opinions, we tend to overvalue information that reinforces them and undervalue information that undermines them (conservatism bias).

[/ QUOTE ]

Another old saying fits here methinks, don't fall in love with your stocks.

[ QUOTE ]
Overoptimism: We tend to be overoptimistic and overconfident. According to James Montier, when students are asked whether they will perform in the top half of their class, an average of 80 percent say yes.

[/ QUOTE ]

Greed IMO.

[ QUOTE ]
This tendency makes it easier for part-time hobbyists to dismiss a century's worth of academic research showing that only a tiny fraction of full-time professionals can beat the market.

[/ QUOTE ]

I concur with this statement.

[ QUOTE ]
Outcome Bias: We tend to evaluate decisions based on outcomes instead of probabilities. Thus, we congratulate ourselves for stupid choices that happen to turn out well and vow to never again make smart choices that happen to turn out badly. Our errors get reinforced, and our wise decisions rejected.

[/ QUOTE ]

I concur with this as well.

[ QUOTE ]
Buffett's "Rearview Mirror": We base our expectations for the future on what has happened in the recent past. Thus, we are most bullish at the end of long bull markets, when we should be most bearish, and most bearish at the end of long bear markets, when we should be most bullish.

[/ QUOTE ]

Definitely saw this at the end of the last bear market and the previous bull market.

[ QUOTE ]
Hindsight Bias: When we reflect on the past, we imagine that we knew what was going to happen when we didn't. As James Montier puts it, "You didn't know it all along, you just think you did." This allows us to imagine, for example, that we knew that the tech boom of the late '90s was a bubble and that everyone who suggested otherwise was an idiot or crook. It also makes us overconfident about our ability to predict what will happen next.

[/ QUOTE ]

It's amazing how difficult it is to be accurate with predictions of the future.

I would also add that IMO the concept of risk is not understood all that well by most.