1. Overconfidence Investors are as overconfident about their trading abilities as about their driving abilities.

People significantly overestimate the accuracy of their forecasts. So when investors are asked to estimate the profits for a firm one year from now and to express the figures in term of a range where they are confident that the actual result has a 95% chance of being within the projected range, they give a range that is far too narrow. Investors make bad bets because they are not sufficient aware of their informational disadvantages. This line of research may help explain the underreaction effect. Investors experience unanticipated surprise at, say, earnings announcements because they are overconfident about their earning predictions. It takes a while for them to respond to new information in the announcement (due to conservatism) and so prices adjust slowly. This may contribute to price momentum and earning momentum. Overconfident may be caused at least in part by self attribution bias. That is investors ascribe success to their own brilliance but failures in stock picking to bad luck. Overconfidence may be a cause of excessive trading because of investors believe that they can pick winners and beat the market. Inexperienced investors are apparently more confident that they can beat the market than experienced investors. 2. Representativeness Is the making of judgement based on stereotypes. It is the tendency to see identical situations where none exist. For example, if Michael is an extrovert, the life and soul of the party, highly creative and full of energy, people are more likely to judge that he is an advertising executive than a postman. Representativeness can be misleading. Michael is more likely to be a postman than an advertising executive even though he 'sound' to be typical of advertising executives: there are far more postmen than advertising executives. People overweight the representative description and underweight the statistical base evidence. If there is a sharp decline in the stock market, as in 1987 or 2001, you will read articles pointing out that this is 1929 all over again. These will be backed up by a chart showing the index movement in 1929 and recent index movements. The similarities can be striking but this does not mean that the Great Depression is about to be repeated or even that share prices will fall for the next three years. The similarities between the two situations are superficial. The economic fundamentals are very different. Investors tend to give too much weight to representative observation (eg share price movements) and underweight numerous other factors.

Representativeness may help explain the return reversal effect. People look for patterns. If a share has suffered a series of poor returns investors assume that this pattern is representative for that company and will continue in the future. They forgot that their conclusion could be premature and that a company with three bad years can produce several good profit figures. Similarly investors overreact in being too optimistic about the shares that have had a lot of recent success. It may also explain why unit trusts and investment trusts with high past performance attract more of investors' capital even though studies have shown that past performance is a poor predictor of future performance - even poor quality managers can show high returns purely by chance. 3. Conservatism Investors are resistant to changing opinions, even in the presence of pertinent new information. So when profits turn out unexpectedly high they initially underreact. They do not revise their earnings estimates enough to reflect the new information and so one positive earnings surprise is followed by another positive earnings surprise. 4. Narrow Framing Investor's perceptions of risk and return are highly influenced by how the decision problems are framed. Many investors' "narrow frame" rather than look at the broader picture. For example, an investor aged under 35 saving for retirement in 30 years pays too much attention to short-term gains and losses on a portfolio. Another investor focuses too much on the price movement of a single share, although it represents only a small proportion of total wealth. This kind of narrow framing can lead to an over-estimation of the risk investors are taking, especially if they are highly risk averse. The more narrow the investor's focus, the more likely he is to see losses. if the investor took a broad frame he would realise that despite short-term market fluctuations and one or two down years the equity market rises in the long term and by the time of retirement a well diversified portfolio should be worth much more than it is today. Likewise, by viewing the portfolio as a whole the investor does not worry excessively about a few shares that have performed poorly. Benartzi and Thaler (1995) show evidence suggesting that framing errors cause investors to avoid equities in favour of risk-free government securities, thus missing out on the much better returns on equities. Investors evaluated the riskiness of shares in a time horizon that was too short, say once a year, or even once a month. 5. Ambiguity aversion People are excessively fearful when they feel that they do not have very much information. On the other hand they have an excessive preference for the familiar on which they feel they have good information: as a result they are more likely to

gamble. For example, ambiguity aversion may explain the avoidance of overseas shares despite the evidence of the benefits of international diversification. 6. Positive feedback and extrapolative expectations Stock market bubbles may be at least partially explained by the presence of positivefeedback traders who buy shares after prices have risen and sell after prices fall. They develop extrapolative expectations about prices. That is simply because prices rose(fell) in the past and a trend has been established investors extrapolative the trend and anticipate greater future price appreciation (falls). This tendency has also been found in house prices and in the foreign exchange markets. George Soros describes in his books (1987, 1998) his exploitation of this trend-chasing behaviour in a variety of financial and real asset markets. Here the informed trader (eg Soros) can buy into the trend thus pushing it along further away from fundamental values in the expectation that uninformed investors will pile in and allow the informed trader to get out at a profit. Thus the informed trader creates additional instability instead of returning the security to fundamental value through arbitrage. 7. Regret Experimental psychologists have observed that people will forgo benefits within reach in order to avoid the small chance of feeling they have failed. They are overly influenced by the fear of feeling regret. 8. Confirmation bias People desire to find information that agrees with their existing views. Information that conflicts is ignored. For example, in 2007 many people ignored the arguments suggesting property prices might fall. 9. Cognitive dissonance If a belief has been held for a long time people continue to hold it even when such a belief is plainly contradicted by the evidence. People experience mental conflicts when presented with evidence that their beliefs or assumptions are wrong, resulting in denial for a considerate period. 10. Availability bias People may focus excessively on a particular fact or event because it is more visible, fresher in the mind or emotionally charged at the expense of seeing the bigger picture. The bigger picture may incorporate soundly based probabilities. For example, following a major train crash, people tend to avoid train travel and uses their cars more. However, the bigger picture based on statistical evidence reveals that train travel is far safer than road transport. In financial markets, if some particularly high-profile companies in an industrial sector (eg IT) have produced poor

results, investors might abandon the whole sector, ignoring the possibility that some excellent companies may be selling at low prices. They overweight the prominent news. 11. Miscalculation of probabilities Experiments have shown that people attach too low a probability to likely outcomes and too high a probability to quite unlikely ones. Can this explain the low valuations of "old economy" shares in the late 1990s as the technological revolution was in full swing? Did investors underestimate these companies' prospects for survival and their ability to combine the new technology with their traditional strengths? At the same time did investors overestimate the probability of all those dotcom start-ups surviving and becoming dominant in their segments? 12. Anchoring When people are forming quantitative assessments their views are influenced by suggestion. So, for example, people valuing shares are swayed by previous prices. Their anchor their changes in valuation on the value as suggested in the past. This may contribute to understanding post-earnings-announcement drift as investors make gradual adjustments to historic figures.