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MARKET STRUCTURE

THE PSYCHOLOGY BEHIND


COMMON INVESTOR MISTAKES
By R. Douglas Van Eaton

Standard finance Behavioral finance, a relatively new area of financial research, has been
receiving more and more attention from both individual and institutional
models assume that investors. Behavioral finance combines results from psychological studies of
investors behave like decision-making with the more conventional decision-making models of
Star Trek’s Mr. Spock, standard finance theory.
taking in information By combining psychology and finance, researchers hope to better explain
and making logically certain features of securities markets and investor behavior that appear
irrational. Standard finance models assume that investors are unbiased and
“correct” decisions. quite well informed. Investors are assumed to behave like Mr. Spock from
Behavioral finance Star Trek, taking in information, calculating probabilities and making the
introduces the logically “correct” decision, given their preferences for risk and return.
possibility of less- Behavioral finance introduces the possibility of less-than-perfectly-rational
than-perfectly- behavior caused by common psychological traits and mental mistakes.
Six common errors of perception and judgment, as identified by psycholo-
rational behavior gists, are examined in this article. Each has implications for investment
caused by common decision-making and investor behavior. An understanding of the psychological
psychological traits basis for these errors may help you avoid them and improve investment
and mental mistakes. results. And in some cases, market-wide errors in perception or judgment can
lead to pricing errors that individuals can exploit. Understanding the psycho-
logical basis for the success of momentum and contrarian strategies can help
investors fine-tune these strategies to better exploit the opportunities that
collective mental mistakes create.

OVERCONFIDENCE

A good starting point for a list of psychological factors that affect decision-
making is overconfidence. One form is overconfidence in our own abilities. A
great number of psychological studies have demonstrated that test subjects
regularly overestimate their abilities, especially relative to others. Studies also
show that people tend to overestimate the accuracy of information. With
respect to factual information, research subjects consistently overestimated the
probability that their answer to a question was correct.
You might expect that professional stock analysts are less prone to psycho-
logical biases than non-professional investors and the general public. With
regard to overconfidence, however, this is not the case. A leading researcher
found that when analysts are 80% certain that a stock is going to go up, they
are right about 40% of the time.
How does overconfidence affect investment behavior?
Models of financial markets with overconfident investors predict that
trading will be excessive. One recent study used a creative approach to see if
overconfidence is related to high levels of trading. Many psychological studies
have shown that men are more prone to overconfidence than women. If
overconfidence causes overtrading, then men should exhibit their greater
tendency toward overconfidence by trading more. The results of the study
show exactly that—for a large sample of households, men traded 45% more
than women, and single men traded 67% more than single women over the

R. Douglas Van Eaton, CFA, is a professor of finance in the College of Business


Administration at the University of North Texas in Denton, Texas.

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MARKET STRUCTURE

period of the study. events, and exclude circumstances the position would finalize the error
Is the active trading that overconfi- that suggest a different outcome. and the pain of regret is delayed by
dence leads to actually ‘excessive,’ The cry of “this time it’s different” not accepting the purchase as an
causing lower performance? A study has a special place in investment error. Winning stocks, on the other
of the trading activity and returns lore. It is perilous to ignore stock hand, contain the seeds of regret.
for a large national discount broker- market history based on a belief that The sale of appreciated shares
age suggests that it is. For all of the present circumstances make histori- removes the possibility that those
households, returns averaged 16.4% cal market performance irrelevant to shares will fall in value along with
over the period. However, those that current decisions. the potential for regret should this
traded the most averaged 11.4% in occur before the shares are sold.
annual returns, significantly less than FEAR OF REGRET Besides avoiding poor decisions from
for an account with average turn- too much focus on the fear of regret,
over. Over the same period, the S&P A second mental error that can you may also be able to improve
500 returned 17.9% on average. affect decision-making is an excessive performance by exploiting pricing
What, if anything, can investors do focus on the potential feelings of patterns that result from behavior
about the general tendency toward regret at having made a poor decision rooted in the fear of regret. A
overconfidence? (or a ‘good’ decision that turns out general tendency among investors to
You can profit from this research poorly). This type of error is rooted hold on to losers too long will slow
only by heeding its message: Trade in most individuals’ (sometimes the price declines, since less shares
less. This is perhaps more easily said extreme) dislike for admitting they are offered for sale. Similarly, a
than done. Placing too much confi- are wrong. The tendency to feel tendency to sell winners too soon
dence in an analyst’s buy/sell recom- distress at having made a mistake will increase the number of shares
mendation or earnings projection that is out of proportion to the size for sale and slow price increases.
may lead to excessive trading even and nature of the error is what Both of these effects can enhance
without any illusions about your own psychologists label the “pain of opportunities for investors.
stock-picking abilities. regret.” The fear of regret manifests Strategies based on price momen-
Other aspects of overconfidence are itself when the potential regret from tum and earnings momentum seek to
more subtle. People prefer to bet on making an error has an influence on exploit the fact that price changes
the flip of a coin if it has not already our decision-making that is out of occur slowly, over a sometimes
been tossed. Psychologists relate this proportion to the actual penalty an prolonged period of time. Studies
to a tendency for people to believe error would impose. Some behavioral show that stocks that have per-
that they either have some ability to models are constructed around the formed the best (or worst) over six
foretell the future or some control idea that people make decisions so as months to a year are likely to
over the outcomes of future events. to minimize the potential regret that remain good (or poor) performers
Another behavior that is related to may result. over the next year. There has been
overconfidence in our abilities is the The fear of regret influences considerable research over the years
tendency to treat historical informa- behavior when individuals procrasti- showing that firms that announce
tion as irrelevant and to place much nate in making decisions. Studies surprisingly good (or poor) quarterly
more importance on current circum- have shown that people will post- earnings tend to outperform (or
stances as a determinant of future pone a decision, claiming that they underperform) for up to a year after
outcomes. The psychological basis are awaiting an upcoming informa- the earnings announcement.
for such a tendency is called “his- tion release, even when the new While the success of momentum
torical determinism,” the belief that information will not change their strategies may also be a result of
historical events could or should decision (called the disjunction effect other psychologically driven behav-
have been predictable given the by psychologists). iors, a tendency to sell winners too
circumstances of the past. For The fear of regret can play an soon and losers too late will, in
investors, this translates to a belief important role in our investment general, make price adjustments to a
that market events, such as the 1929 decision-making in other ways as new equilibrium level a more drawn-
crash, could not have developed any well. In stock transactions, acting so out process than it would otherwise
other way. Only if we determine as to avoid the pain of regret can be. Investors can purchase stocks of
that current circumstances mirror lead to holding losing stocks too firms that are in an established
those of some past time period will long and selling winners too soon. uptrend, with both earnings and
we be inclined to give history its When stocks go down in value, price momentum, and hold them
due. Our collective social memory investors seem to delay the selling of until the trend has reversed. For
may tend to emphasize things that those stocks, even though they likely stocks that show a negative trend in
are seen as directly causing past have not met expectations. Selling earnings and price, the message here

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MARKET STRUCTURE

is: Get out. The deterioration will Another disciplined approach is to set Understanding the role of anchor-
likely be longer and more severe than a time limit for a newly purchased ing in the decision-making process
you think. Such discipline should stock to perform as expected. If, for can help you avoid some investment
reduce the tendency to sell winners example, the earnings and/or price pitfalls. “Bottom fishing,” the
too soon and hold losers too long, expectations have not been met after practice of buying stocks that have
and improve investment results. three months, then the stock must go. fallen considerably in hopes of
While this is not necessarily a good getting them cheaply, can be quite
COGNITIVE DISSONANCE rule for value investors (since that hazardous to your wealth. The
approach often requires longer motivation behind this strategy is
A psychological characteristic that is holding periods before expectations similar to the concept of anchoring.
related to the fear of regret is the desire are met), it can help those who A higher recent price is taken as
to avoid cognitive dissonance. This pursue a growth strategy to avoid evidence of value, so that the new
psychological trait is one you might holding losing positions over a price seems cheap.
remember from Psychology 101. prolonged period of price deteriora- The old pros say, “Don’t bottom
Without the jargon, the reference is to tion. fish,” but they also say “Buy on
a desire to avoid believing two conflict- weakness.” What’s the difference?
ing things. If one of the beliefs is ANCHORING If you have evaluated a stock and
supported by emotional involvement or determined that you would like to
attachment, the brain will attempt to The three psychological character- accumulate a position, then you can
avoid or discount a conflicting belief istics discussed so far are all based, and should time your buys to take
and seek out support for the preferred to some extent, on feelings and advantage of the ebbs and flows in
belief. emotions. But some decision- the market and price weakness in
In the classic study of this character- making errors result from mental the stock when it goes below your
istic, researchers found that once a shortcuts that are a normal part of buy price. If, on the other hand, a
person had made a decision and the way we think. The brain uses sharp price decline lies behind the
purchased a particular automobile, mental shortcuts to simplify the decision to buy and a recent higher
they would avoid ads for competing very complex tasks of information price looms large in the stock’s
models and seek out ads for the model processing and decision-making. initial attraction, beware—the odds
purchased. Avoiding the pain of regret Anchoring is the psychologists’ are against you.
may be the basis for this behavior. One term for one shortcut the brain One effect of anchoring on
way to avoid regretting the purchase uses. The brain approaches complex investment decisions is similar to
decision is to (irrationally) filter the problems by selecting an initial that of the fear of regret; losing
information received (or believed) after reference point (the anchor) and positions will be held too long and
the decision has been made. Alterna- making small changes as additional improving stocks will be sold too
tively, people can minimize the impor- information is received and pro- soon. In each case the effect of a
tance of subsequent information that cessed. This reduces a complex recent price as a psychological
would call their original decision into problem, evaluating all information anchor in the complex process of
question, if the truth can’t be avoided as a whole as new information is stock valuation will slow the
or denied. Beliefs that we wish to received, to the simpler task of revision of valuation estimates.
maintain are defended by many revising conclusions as each new bit Losers will appear cheap and
mechanisms, even if the strong desire of information is received. winners will seem to have gotten
to maintain existing beliefs has a less- In the case of bargaining, a ahead of themselves. As with the
than-rational basis. salesman may begin with a high fear of regret, anchoring can slow
How can you adjust for the tendency price to bias upward the final price. the process of revaluation and
to avoid or deny new, conflicting Research shows that the listing contribute to the gains from mo-
information? As in other areas, prices for homes influence estimates mentum strategies. In general, the
investment discipline can help. By of their values. The listing price less clear the underpinnings of a
writing down the reasons for purchas- apparently serves as an anchor, stock’s value, the greater the
ing a stock and re-evaluating their even though it does not necessarily importance of an anchor in the
validity over time as dispassionately as contain relevant information about process of establishing value. The
possible, investors can force themselves the home’s value. Recent prices or valuations of highly speculative
to maintain a selling discipline. If the recent earnings performance may stocks, such as Internet high flyers
reasons for purchase no longer hold serve as a similar psychological without visible earnings, will likely
and the share price indicates deteriorat- anchor for investors, and may have be more influenced by recent prices,
ing fundamentals, admitting a mistake predictable effects on subsequent than those of stocks with visible
may often be the prudent thing to do. returns. and predictable earnings.

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REPRESENTATIVENESS unchanged. This collective classifi- comes for the whole period, they
cation can lead to stocks being are more likely to make the correct
Another shortcut that the brain unloved and underpriced. A value decision.
uses to reduce the complexity of investor seeks to buy the stocks
thought is called representativeness others classify as “bad,” ideally at SUMMARY
by psychologists. This is an assump- the time when the greatest majority
tion the brain makes that things holds this view. When fundamen- A better understanding of the
that share similar qualities are quite tals have started to deteriorate but psychology of investor mistakes can
alike. Classifications are made the majority of investors have not reduce their effects on investment
based on a limited number of yet reclassified the stock in their decisions. Here is a list of the most
shared qualities. minds, it is often an ideal time to common psychological effects, and
One example of representativeness sell. how you can reduce their impact
in our thinking is the tendency to and incorporate them into your own
classify people as either “good” or MYOPIC RISK AVERSION investment decisions:
“bad” based on some short list of • Overconfidence: Trade less,
qualities. When we do this, we gain The term “myopic risk aversion” especially in taxable accounts. In
in simplicity and speed, but at the refers to the tendency of decision terms of probabilities, you are not
expense of ignoring the much more makers to be shortsighted in their as good at investment decisions as
complex reality of the situation. choices about gambles and other you think you are. Discount the
The effect of representativeness in activities that involve potential opinions of analysts, who tend to
investment decisions can be seen losses. Much research has examined go to extremes, either overly
when certain shared qualities are what types of gambles people will confident or overly pessimistic.
used to classify stocks. Two compa- accept, the effects of how the • Fear of regret/pain of regret:
nies that report poor results may possible outcomes of the gamble are Don’t let the prospect of regret at
both be classified as poor compa- presented, and whether people making a decision that turns out
nies, with bad management and make consistent choices. poorly have disproportionate
unexciting prospects. This may not As an example of how these weight in your decisions. Con-
be true, however. A tendency to results can apply to investment vince yourself that unrealized
label stocks as either bad-to-own or decision-making, consider an losses are equivalent to realized
good-to-own based on a limited investor saving for retirement. Each losses.
number of characteristics will lead year’s investment in equities rather • Cognitive dissonance: Seek out
to errors when other relevant than a lower-risk alternative can be contrary opinion. Research
characteristics are not considered. viewed as a single gamble. Unlike doesn’t stop when a purchase is
Representativeness may also be casino gambling, however, the made. Strive to identify your
related to the tendency of stock expected payoff is positive, and the mistakes as early as possible and
prices to reach extremes of valua- investor has the opportunity to take pride in the ability to do so.
tion. If poor earnings and share invest in equities over a period of • Anchoring: Be aware of how
price performance has a stock many years. recent prices, earnings and growth
branded as “bad,” representative- Two leading researchers in rates can serve as psychological
ness will tend to delay the reclassi- behavioral finance have concluded anchors in thought processes.
fication of the stock as one inves- that investors in this situation tend Avoid price-driven “bottom
tors would like to own. On the to hold less than the optimal fishing.”
other hand, “good” stocks may amount of equities because they • Representativeness: Step back and
continue to be classified as such by place too much emphasis on the look at the whole picture on a
investors well after the firm’s potential loss from a single year’s stock. Don’t place too much
prospects for either earnings or investment in equities. They term emphasis on a few qualities that
price appreciation have diminished this shortsightedness myopic risk good stocks or loser stocks share.
significantly. aversion. Winners turn into losers and vice
Contrarian or value strategies In one study, investors in a versa, so be open to their chang-
seek to exploit just such erroneous company retirement plan chose ing nature.
classifications. If a firm has been larger equity allocations after they • Myopic risk aversion: Long-term
classified by most investors as a were shown the actual results of investors should make asset
bad one and the stock as a loser, investing in equities over many allocation decisions based on
initial changes in the company’s different 20-year periods. The possible multi-year outcomes and
outlook may leave the classifica- research suggests that if investors not focus on single-period return
tion in investors’ minds essentially focus on the distribution of out- possibilities. ✦

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