Investment Madness : How Psychology Affects Your Investing...and What to Do About It

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WARNING: Allowing emotion to invade your investment decisions can be hazardous to your wealth.

Think about your investments more clearly

How overconfident investors trade too much, take too many risks, and earn lower returns

The ...

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Overview

WARNING: Allowing emotion to invade your investment decisions can be hazardous to your wealth.

Think about your investments more clearly

How overconfident investors trade too much, take too many risks, and earn lower returns

The investment impact of your self-image

Why avoiding feelings of regret now will cause you even greater regrets later

Yesterday's trade, today's emotions, tomorrow's mistake

Placing your recent investment experiences in realistic perspective

The devil you know versus the devil you don't

Familiarity breeds investment—but not necessarily profit

Is your memory playing tricks with you?

You're not alone. We'll tell you what to do about it

Not all information is alike

Avoiding herd mentality: your chat room, your brother-in-law, and other temptations. Remember when dotcoms were going to end business as we know it?

How your psychology reduces your profits and increases your risks-and what to do about it!

Why'd you fall for that Internet stock?

Why'd you keep money in cash when it could've earned far better returns elsewhere?

Why haven't you fully funded your retirement plan when you know you should?

Why do you always seem to buy high and sell low?

Why does it look like everyone else is getting rich but you?

It's your psychology. It's your emotions. As an investor, they're your biggest obstacles. They cut your returns, and raise your risks. It's about time you did something about it. Investment Madness will show you how. Drawing on the new science of behavioral finance, Dr. John Nofsinger shows you how to:

See through the "illusion of control" that makes you overconfident about your investments

Objectively evaluate the stocks and financial instruments you've inherited

Recognize the feelings of pride, regret, and herd behavior that lead to disaster

Improve your "mental accounting"—and your portfolio's diversification

With today's instantaneous Internet-based trading, your psychological biases have become more dangerous than ever. Investment Madness delivers expert techniques and mental strategies that will empower you with true self-control—the decisive factor in investment success.

Avoiding herd mentality: your chat room, your brother-in-law, and other temptations. Remember when dotcoms were going to end business as we know it?

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Product Details

  • ISBN-13: 9780130422002
  • Publisher: Pearson Education
  • Publication date: 7/5/2001
  • Series: Financial Times Series
  • Pages: 192
  • Product dimensions: 6.30 (w) x 9.84 (h) x 0.78 (d)

Meet the Author

Dr. John Nofsinger is a finance professor at Washington State University. His 1997 paper, "Herding and Feedback Trading by Institutional Investors" written with Richard W. Sias, was awarded "Best of the Best" and "Best Paper in Investments" by the Financial Management Association. He has also done advanced research for the New York Stock Exchange and the Association for Investment Management and Research. Nofsinger holds a doctorate from Washington State University.
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Table of Contents

INTRODUCTION.

1. Your Behavior Matters!
Why haven't I Heard of This Before? A simple Illustration. Prediction. Behavioral Finance. The Investment Environment. Endnotes.

I. NOT THINKING CLEARLY.

2. Overconfidence.
Becoming Overconfident. Illusion of knowledge. Illusion of Control. Recipe for Disaster? Endnotes.

3. Overconfidence and Investing.
Overconfidence: A Case Study I. Overconfidence and Trade Frequency. Gender Differences. Trading Too Much. Overconfidence and Risk. Overconfidence and Experience. Mutual Funds. Overconfidence and the Internet. Summing Up. Endnotes.

4. Status Quo - Or What I Own Is Better!
Endowment Effect. Endowment and Investing. Status Quo Bias. Attachment Bias. Overcoming These Biases. Endnotes.

II. EMOTIONS RULE.

5. Seeking Pride and Avoiding Regret.
Disposition Effect. Do We Really Sell Winners? Selling Winners Too Soon and Holding Losers Too Long. The Disposition Effect and the Media. Avoiding the Avoiding of Regret. In Summary. Endnotes.

6. Double or Nothing.
House Money Effect. Snake-Bit (Risk Aversion) Effect. Break-Even Effect. Would You Buy This IPO? The Tech Bubble. Endnotes.

7. Social Aspects of Investing.
Sharing Investment Knowledge. Moving with the Hotel. Speed Is of the Essence (Not). Investment Clubs. Beardstown Ladies. Investment Club Performance. Investment Club and Social Dynamics. Summing Up. Endnotes.

III. FUNCTIONING OF THE BRAIN.

8. Mental Accounting.
Mental Budgeting. Matching Costs to Benefits. Aversion to Debt. Sunk-Cost Effect. Economic Impact. Mental Accounting and Investing. Endnotes.

9. Mental Accounting and Diversification.
MentalAccounting and Portfolios. Risk Perceptions. Risk Perception in the Real World. Building Behavioral Portfolios. Summing Up. Endnotes.

10. That's Not the Way I Remember It.
Memory and Investment Decisions. Cognitive Dissonance. Cognitive Dissonance and Investing. Cognitive Dissonance and the Steadman Funds. Memory and Socialization. Reference Points. Summing Up. Endnotes.

11. What I Know Is Better.
Representativeness. Representativeness and Investing. Familiarity. Familiarity Breeds Investment. Familiarity Breeds Investment Problems. Endnotes.

IV. INVESTING AND THE INTERNET.

12. The Internet (Psycho) Investor.
The Rise of the Internet Investor. Amplifying Psychological Biases. Information and Control. Online Trading and Overconfidence. Advertising - Increasing the Biases. Online Trading and Performance. Day Traders - The Extreme Case. Summing Up. Endnotes.

13. Exuberance on (and about) the Net.
A Rose.com by Any Other Name. A Bubble Burst. The More Things Change. The Boiler Room Goes Online. Endnotes.

V. WHAT CAN I DO ABOUT IT?

14. Self-Control, or the Lack of It!
Short-Term versus Long-Term Focus. Controlling Oursleves. Rules of Thumb. Environment Control. Self-Control and Saving. IRA's. 401 (k) Plans. Self-Control and Investing. Self-Control and Dividends. Summing Up. Endnotes.

15. Battling Your Biases.
Strategy 1: Understand Your Psychological Biases. Not Thinking Clearly. Letting Emotions Rule. Functioning of the Brain. Strategy 2: Know Why You are Investing. Strategy 3: Have Quantitative. Investment Criteria. Strategy 4: Diversify. Strategy 5: Control Your Investing. Environment. Additional Rules of Thumb. In Conclusion.

Index.

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Preface

Introduction

We are all prone to having psychological preconceptions or biases that make us behave in certain ways. These biases influence how we assimilate the information we come in contact with on a daily basis. They also have an impact on how we utilize that information to make decisions.

Some of the decisions that are influenced by our psychological biases can have a large impact on our personal wealth - or the lack of it. I have written this book to try to show you how your own psychological biases can creep into your investment decisions and sabotage your attempts at building wealth.

WHAT TO EXPECT FROM THIS BOOK

There are five parts in this book. The first three parts illustrate different psychological biases that affect our daily lives. The chapters in these parts are structured so they are similar to each other. First, I identify the psychological trait and explain using common, daily activities. Then I examine the degree to which investors are affected by the bias. Part 4 demonstrates how the Internet exacerbates these psychological problems. Finally, the chapters in Part 5 describe what investors can do to help themselves.

The chapters in Part 1, "Not Thinking Clearly," demonstrate how investment decision making is not always rational. As you will see, people set their range of possible outcomes too narrowly. This is part of a broader problem called overconfidence. Overconfident investors trade too much, take too much risk, and earn lower returns. This topic is discussed in Chapter 2 and 3. If overconfidence causes investors to act too frequently, other biases described in Chapter 4 causes investors tofail to act when they should.

Part 2, "Emotions Rule," shows how the emotions associated with investing affect our decisions. Chapter 5 illustrates how an investor's view of himself causes him to avoid feelings of regret and to seek pride. Consequently, investors sell winner stocks too soon and hold onto loser stocks too long. Chapter 6 demonstrates that your past failures and successes have a dramatic impact on your current decision making process. Lastly, our emotional state is often affected by the social aspects of investing; we discuss this in Chapter 7.

The third part, "Functioning of the Brain," shows how the human brain's processes for interpreting and remembering information affect investors. For example, every day you are bombarded by information. The brain uses a process called mental accounting to store and keep track of important decisions and outcomes. Chapter 8 shows that as a consequence of this process, people make poor financial decisions. Discussed in Chapter 9 is one particularly important implication of how investors view portfolio diversification. The brain also uses shortcuts to quickly process information. This leads to impacts on investor memory (Chapter 10) and the problem of representativeness and familiarity (Chapter 11).

Part 4, "Investing and the Internet," discusses the interaction among the Internet, psychology, and investing. The Internet allows investors quick access to information, trading, and other investors' opinions. However, these attributes actually magnify the psychological biases. These issues are addressed in Chapters 12 and 13.

Finally, part 5, "What Can I Do About It?" discusses what the investor can do to avoid these psychological biases. The difficulty of maintaining self-control in the face of the psychological biases is illustrated in Chapter 14. The last chapter shows that planning, incentives, and rules of thumb are helpful in avoiding the common problems.

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  • Anonymous

    Posted July 16, 2001

    Investors Are Overconfident . . . and That's Costly!

    Professor Nofsinger has written the best summary of behavioral finance concerning financial investing that I have seen. Anyone who is thinking about starting out with investing or is dissatisfied with her or his results should read the book. You will save thousands as a result! Financial thinkers historically assumed that all investors were absolutely rational and logical. Nothing could be further from the truth. Instead, investors misperceive what is going on around them, assume the best, overestimate their competence, and let emotion whipsaw them (brilliantly displayed with a roller coaster illustration in the book). You will read simple, clear summaries of the research that document these flaws. Here are a few examples. Those who trade the most do the worst. Go on-line, and you will trade more and hurt your returns. People enjoy the validation they get from having been right, so they prefer to sell winners too soon in order to have that experience rather than make the best economic decision (to dump a low-potential loser and get a tax loss) which will make them feel like they have failed. Most people think it is less risky to buy good management. But those stocks have huge downside risk if management stumbles, while those with lousy management have little further downside risk in many cases. The book also takes a great look at the Internet bubble. My complaint with the book is that it is overconfident in prescribing solutions. Although the suggestions (if followed) should help, most investors will still trail the market averages. Why doesn't the book make the case for investing in indexed mutual funds? I graded the book down one star for being weak in this area. The behavioral finance people have done great work in explaining why people do poorly. What they haven't done is run experiments on how to improve investor behavior. This is like telling people it's bad to be overweight, and suggesting that they eat less. That won't lead to weight loss for most people. I hope in the future that Professor Nofsinger will run experiments to find the best ways to help people change their bad habits to better ones. Certainly, his ideas (follow rules of thumb, pay less frequent attention, and quantify your decisions) could potentially help . . . if you can overcome the emotions and misperceptions that drove you to do the wrong thing while feeling comfortable as you did it. After you read this book, I suggest that you next read John Bogle's Common Sense on Mutual Funds. Those prescriptions will work better than the ones here for 90 percent of investors, in my experience. You should also think about where else in your life emotion can cause you to sabotage your self interests. How are effective are you in making economic decisions that affect your family and friends? I suspect that many of these same issues apply in other parts of your life. Learn to take the right risks . . . to reap greater rewards from the same efforts! Donald Mitchell, co-author of The Irresistible Growth Enterprise and The 2,000 Percent Solution

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