By Albert Phung
Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that you can identify some of the biases, it's time to apply that knowledge to your own investing and if need be take corrective action. Hopefully, your future financial decisions will be a bit more rational and lot more lucrative as well.
Here is a summary of what we've covered:
- Conventional finance is based on the theories which describe people for the most part behave logically and rationally. People started to question this point of view as there have been anomalies, which are events that conventional finance has a difficult time in explaining.
- Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler.
- The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
- Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money's source and intent.
- Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to be more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
- The gambler's fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
- Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
- Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
- Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
- Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
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