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Investor psychology: Know your biases

Investor biases fall into three categories:

1. Not thinking clearly:

  • Overconfidence -- precipitated by the illusion of knowledge and the illusion of control, it causes investors to trade too much and take too much risk.
  • Attachment -- leads investors to focus on a security's good traits and ignore bad signs.
  • Endowment -- when securities are given to an investor, the investor tends to keep them.
  • Status quo -- leads to procrastination.
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2. Emotions rule:

  • Seeking pride -- causes investors to sell winners too soon.
  • Playing with the house's money -- prompted by a winning streak that causes investors to take undue risks.
  • Avoiding regret -- causes investors to hold losers too long.
  • Snake-bit -- prompted by a bad investment that causes investor to avoid risk entirely.
  • Getting even -- prompted by a loss, clouds judgment and leads to greater risk-taking.

3. The way the brain works:

  • Cognitive dissonance -- filters information, changing recollections of bad experiences and impairing an investor's ability to properly evaluate investment choices.
  • Representativeness -- the brain's way of reducing complexity by making shortcuts and judging information based on stereotypes or previous experiences, leading investors to put too much faith in stocks that are familiar or represent desirable qualities.

From: Investment Madness: How Psychology Affects Your Investing ... And What to Do About It by John S. Nofsinger.

-- Updated: May 11, 2004

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