The psychology of investing 2nd edition
John R. Nofsinger
I read this book a long long time ago and had written down some pointers but forgotten about it.. so here's what I noted down (and hope I still make sense).
Behavioral finance
Overconfidence affects investor decision.
Men tends to be more overconfident that women in tasks perceived to fall into the masculine domain, such as managing finances.
Over confidence also affects investors’ risk-taking behaviour.
Illusion of knowledge
Over confidence comes partially from the illusion of knowledge. This refers to the tendency for people to believe that the accuracy of their forecasts increases with more information.
E.g. When you roll a six-sided die, you should have 1/6 of a chance of getting any no from 1-6. but if the last 3 rolls u rolled a 4? You start to waver even though the probability did not change.
Illusion of control
Online investors can routinely experience these attributes.
Choice: make your own choice what and when to buy/sell
Outcome Sequence: positive outcome during bull market
Task Familiarity: more familiar people are with a task, the more they feel in control of the task
Information: greater amt of info is obtained, the illusion of control is greater as well
Active involvement: participates a great deal in a task, the feeling of being in control is also proportionately greater.
Past success: the more successes people experience, the more they will attribute it to their own ability, even when much luck is involved.
Online trading exacerbates the overconfidence problem, inducing excessive trading. Ultimately, investor returns are reduced.
Individual investors can be overconfident about their abilities, knowledge and future prospects. Overconfidence leads to excessive trading, which lowers portfolio returns. The lower returns result from the commission costs associated with high levels of trading and the propensity to purchase stocks that underperform the stocks that were sold. Overconfidence also leads to greater risk taking due to underdiversification and a focus on investing in small companies with higher betas. Last, the trend of using online brokerage accounts is making investors more overconfident than ever before.
Pride and Regret
Selling winners too soon and holding loses too long.
People act or fail to act to avoid regret and seek pride, which causes investors to sell their winners too soon and hold their losers too long. This behaviour hurts investor wealth in two ways. First, investors pay more capital gains taxes because they sell winners. Second, investors earn a lower return because the winners they sell and no longer have continue to perform well, while the losers they still hold continue to perform poorly.
House-money effect: After people have experience a gain or profit, they are willing to take more risks.
Risk-aversion or snake-bite effect: People becomes more cautious and avoid risk
Trying-to-break-even effect: People jump at the chance to make up their losses.
Effect on investors
The house-money effect predicts that investors are more likely to purchase risky stocks after closing out a successful position. In other words, after locking in a gain by selling stock at a profit, investors are more likely to buy higher-risk stocks.
The snake-bite effect
Memory and decision making.
The further the pain trials were in the past, the less painful the students remembered them to be.
Cognitive dissonance and investing
Buy low sell high. Why is it hard to practice. House money effect causes investors to seek riskier investments. This often manifests as the buying of stocks that have already had substantial increases in price. These stocks are risky because expectations have been elevated too much. In short, you buy high. If stock prices decline, you feel snake bit and want out, you sell low. The psychological bias of seeking or ignoring risk because of the house money effect contributes to the creation of a price bubble. The psychological bias of avoiding risk in the snake-bite effect leads to stock prices that are driven too low after the bubble collapses.
Also the human memory is more a recording of emotions and feelings of events than a recording of facts. This can cause investors to remember actual events inaccurately or even to ignore information that causes bad feelings.
Cost/benefit matching of mental budgeting
* pay 6 monthly installments after the washer arrive
* pay 6 monthly installment during 6 months b4 the vacation
Have you ever wonder why prepaid vacation more pleasurable than one that must be paid for later and yet people prefer to work first then get paid??
Aversion to debt
Sunk-cost effect
Negative impact of a sunk cost depreciates with time
Will the family go to the baseball if the storm occurred when
1) tickets bought yesterday : yes
2) tickets bought a year ago : maybe no
Economic impact
People tend to prepay for some purchase and prefer to get paid after doing the work. By accelerating payments and delaying income, they are not taking advantage of the time value of money principles.
Selling a losing stock closed the mental account, triggering regret. Tax swap – sells a stock with losses and purchases a similar stock
Less emotionally distressing for the investor to sell the losing stock later as opposed to earlier
Portfolio theory
1) expected theory
2) level of risk (standard dev of returns)
3) correlation between the returns of each investment
e.g. stock A and B frequently move in opp directions. Buying both stocks creates a portfolio with reduced risk. That is the value of your portfolio varies less over time when you own stocks A and B than it would if you owned only one of those stocks. However, creating a portfolio that reduces risk (in the modern portfolio theory sense) means considering the interaction between different investments. Unfortunately, investors often treat each investment as a different mental account and tend to ignore the interaction between those mental accounts. Therefore the most useful tool in constructing portfolios and reducing risk, the correlation between investments, is difficult to utilize because of mental accounting.
Perceptions on risk.
Viewing each investment as a separate mental account causes investors to misperceive risk.
Standard deviation is a good measure of an investment’s risk. The rank order and magnitude of risk contribution of the three different groups is similar to the risk ranking using standard deviation as the measure.
However standard deviation measures the riskiness of the investment, not how the risk of the portfolio would change if the investment were added. It is not the level of risk for each investment that is important; the important measure is how each investment interacts with the existing portfolio.
e.g. to reduce the risk of your portfolio, you should add real estate and commodities. Viewed by themselves, emerging markets stocks are the most risky investments in the example. However, they would interact with the existing portfolio such that they would reduce the risk of the portfolio, if they were added.
Building behavioral portfolios
1. investors have a goal of safety. Therefore they allocate enough assets in the safest layer (the bottom of the pyramid) as required by their mental accounts. Then mental accounts with higher levels of expected return and risk tolerance could allocate assets to appropriate investments in another layer. For e.g. retired investors need investment income. The income goal is met in a layer of the pyramid with assets invested in bonds and stocks that pay high dividends. After the income goal is met, the retiree’s next goal might be to keep up with inflation. This investor would then have a set of assets in a layer that invests for growth.
Overreaction: too optimistic in predicting future growth and the stock price falls
Companies with high P/E ratios are more glamorous than firms with low P/E ratios
Value stocks outperform glamour stocks using the P/E ratio measure
: good companies don’t always make good investment. Past operating performance of the firm is representative of the future performance, and they ignore info that doesn’t fit this notion.
Familiarity breeds investment
“home bias” e.g. company’s stocks which is lack of diversification. .
Tend to buy more of company’s stock after price increased
People learn through interacting with other people.
The more we talk about investing, the more we do it. Conversation allows rapid exchange of info. Social environment e.g. social norms, similar lifestyle also plays a part.
Trading behaviour is consistent with overconfidence + disposition effect
Herding : magnifies the psychological basis. Feel of the herd instead of the rigor of formal analysis. Feeling of regret on pricing a loser is lower when you know that many others picked the same stock. Misery loves company.
Overvaluation and herding occurs because of human psychology. New economies and new tech are only the rallying cry for the herd. When overconfidence is combined with emotions, a problem results. The problem is magnified when everyone is expert in making psychology-based decisions.
Misattribution bias.
People in good mood view the future differently than people in a bad mood. Emotion drives the process of complex decision making.
Good moods will increase likelihood of investing in risky asset.
Investors who use qualitative methods e.g. fundamental analysis must include educated guesswork about some assumptions.
Sunshine
A lack of sunlight leads to depression which in turn leads to suicide.
Optimism
1) do less critical analysis in making stock decision
2) tend to ignore/downplay negative info about their stock
Price of stock frequently set by the optimistic investor. If many investor optimistic about the stock and many are pessimistic, the price will be driven by the optimistic because pessimistic stay in the sideline while optimistic buy. A stock will have a large number of optimistic and pessimistic when there is a large degrees of uncertainty about the prospects of the stock.
The more things change, the more people stay the same.
Emotions play an important part of the decision making process. Especially for decision involved in a high degree of uncertainty e.g. investment decision. Emotion overcome logic in this process. Too much optimistic leads investors to underestimate risk and overestimate expected performance. Optimistic investor tends to set good buy and be less critical. Pessimistic investor tend to be more analytical. Extended extreme optimism can cause price bubble.
Markets motivated by fear and greed
As Warren Buffett, the best investor of the 20th century, once put it,
"Be fearful when others are greedy and greedy only when others are fearful."
Planner Vs Doer
Doer: consume now instead of later and procrastinates on unpleasant tasks
Planner: save for later consumption and completes unpleasant tasks now
Conflict between desire and willpower. Occurs because people influenced by longterm rational concerns and by more short term emotional factors.
Rules of thumb + envt control leads to decrease desire of willpower
1) understand the biases
2) know why you are investing
3) have quantitative investment criteria
4) diversify
– by enough diff stock types
– little of the firm you works because income already dependent on it
– invest in bonds
5) control your investment
- check your stocks once per month
- make trades only once per month and on the same day
- review portfolio annually to see how it lines up with your specific goals.
1. Avoid penny stocks
2. Avoid Forums: overconfidence fostered, familiarity magnified + artificial social consensus formed
3. Must know more about the stock : are you sure?
4. earn the market return : fully diversify because they inhibit your biases
5. review psychological bias annually
Most importantly, understand yourself. Don’t allow psychological biases to control their decisions.
