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Kudos for your bringing psychology deliberately into the discussion of investment! I look forward to your future installments. I have not seen the book to which you refer, but let me offer what I believe to be a possibly even more common cognitive illusion. (Perhaps the book refers to it?)

I refer to the "illusory correlation." In short, this illusion is experienced when I DO notice events that confirm my expectations/beliefs, but I do NOT notice events that disconfirm them. Thus, I overestimate confirmations and underestimate the inverse. An old social psychology experiment can serve to illustrate (and I apologize that the reference escapes me.) The experimenter handed participants a stack of newspaper clippings and asked them to briefly look at each one. Each clipping depicted either a Caucasian-American or an African-American, and each article reported that the person portrayed was being arrested for a crime. After handing back the clippings, participants were asked to estimate from memory what percentage of the clippings portrayed each of the two ethnic groups. You might be able to guess that the participants (who were Caucasian) estimated that a majority of the clippings depicted African-Americans, when in fact there was exactly a 50-50 breakdown. This illustrated how prejudicial beliefs can be bolstered by the "illusory correlation," as participants clearly noticed clippings that supported their prejudice, but tended NOT to notice the clippings that disconfirmed prejudice.

The implications for investing are clear, particularly for those who go into the land of trading. Traders (even the "professionals") will tend to overestimate their success rates, based on the illusory correlation. They will remember their "wins" more readily and more readily forget their "losses."

Given these facts, LONG-term investing in good companies is a great way to avoid the pitfalls of the illusory correlation! Chalk another one up for a Foolish approach!

Fool on.

Jeff Bjorck
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