Skip to main content
Message Font: Serif | Sans-Serif
No. of Recommendations: 0
Regardless of what we would like to believe, we rarely are the rational/ efficient/ objective investors assumed by most theories. In fact, the list of 'simplifying' assumptions about our behavior in standard economic models is so stultifying, it makes me wonder which species the author's writing about.

In reality, our investing chatter is full of emotionally charged terms like 'bull run', 'bear rout', 'hot tip', 'pump and dump', etc. Because they portray our in-market behavior so much better than that stuffed shirt 'homo economicus'.

The relatively new field of Behavioral Finance goes a long way toward recognizing our real-life behavior, thus helping us better understand how we really behave as investors.

Here are just a few of the key findings:
- We overestimate our knowledge of an investment, underestimate its risks, and exaggerate our ability to control its outcomes.
- Not realizing that we don't know enough, we take bad bets.
- Overconfidence drives excessive trading frequency

“It's not what a man don't know that makes him a fool, but what he does know that ain't so.”

Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment by Brad M. Barber and Terrance Odean

Endowment effect
- We value things we own more than those we don't.
- We hang on to inherited assets regardless of their fit in our investment profiles
- a.k.a. 'status quo bias': we demand more to give up something than we're prepared to pay for it

Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias, by Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler

Prospect theory

- We are less willing to gamble with profits than with losses
- We sell quickly when we're winning, but avoid selling if we're losing

Prospect Theory: An Analysis of Decision under Risk, by Daniel Kahneman and Amos Tversky

If you're not into slogging through original papers, probably the easiest book to read on the subject is “Why smart people make big money mistakes... and how to correct them” by Gary Belsky and Thomas Gilovich
Print the post  


When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.