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Behavioral economics seeks to explain the psychology of investing. Long-recognized perceptual biases about numbers helps explains some common errors.
"Arrogant and insecure people are reluctant to admit how little they know." People make their distributions too narrow. [A judged 90% confidence interval typically has only a 50% chance of containing the correct value.]
From 1991 to 1996, the average household with accounts at one discount brokerage firm was 17.7 percent. Of the 1/5 of the households with the highest trading volume, i.e., the most confident investors, the average annual return was only 10 percent.
What to do? Trade less often unless you are sure that you are consistently beating and at no greater risk.
People have very different emotions about an asset acquired as a gift versus one acquired by paying with hard-won savings. Belsky uses a hockey game example. Suppose that you have two tickets to a hockey game and you learn that a snowstorm has made the streets dangerous. There is no way to sell the tickets if you do not go.
The point for investors is to forget how much you paid for a stock [neglecting any differential tax effects].
Most people treat money differently, depending upon the amount, whether the amounts are gains or losses, where it came from, and how it is going to be used.
Gamblers typically become more reckless when they are ahead. Investors abandon their investment discipline.
The antidote: Have a sensible system and stick to it.
Gary Belsky is co-author of Why Smart People Make Big Money Mistakes—And How to Correct Them: Lessons from the New Science of Behavioral Economics, 2001, Simon & Schuster Trade Paperbacks, ISBN: 0684859386.
—John Schuyler, August 2001.
Copyright © 2001 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.