7 Ways Your Brain Makes You Lose Money

Sam Ro |

 Nov. 19, 2011, 1:17 PM

Image: Wikipedia

Why don't investors make better decisions?.

"Investors are 'normal,' not rational," says Meir Statman, one of the leading thinkers in behavioral finance.

The aim of behavioral finance is to better understand why people make the financial decisions they do.  And the field of study is becoming widely accepted.  In fact, it's such a crucial part of the Chartered Financial Analyst (CFA) curriculum, a course of study for Wall Street research analysts.

The Psi-Fi Blog (via The Big Picture) has a long list of behavioral biases that affect investor behavior.

We compiled the list of behavioral biases that are addressed in the CFA curriculum. Don't be intimidated.  You might learn something about why you make the financial and investment decision you do.

1. You think you're great at investing.

Image: trackrecord

Overconfidence may be the most obvious behavioral finance concept.  

This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.

Overconfident investors are often underdiversified and thus more susceptible to volatility.

Source: CFA Institute

2. You think the past is an indicator of the future.

Image: Amazon.com

A company might announce a string of great quarterly earnings. 

 As a result, you assume the next earnings announcement will probably be great too.

 This error falls under a broad  behavioral finance concept called representativeness: 

you incorrectly think one thing means something else.

Another example of representativeness is assuming a good company is a good stock.

Source: CFA Institute

3. You don't know how to handle new developments.

Anchoring is related to overconfidence. 

For example, you make your initial investment decision based on the information available to you at the time. 

 Later, you get news that materially affects any forecasts you initially made.  

But rather than conduct new analysis, you just revise your old analysis.

Because you are anchored, your revised analysis won't fully reflect the new information. 

Source: CFA Institute

4. You don't want to book a loss.

Image: Wikimedia Commons

Loss aversion, or the reluctance to accept a loss, can be deadly. 

 For example, one of your investments may be down 20% for good reason.  

The best decision may be to just book the loss and move on.

 However, you can't help but think that the stock might comeback.

This latter thinking is dangerous because it often results in you 

increasing your position in the money losing investment.  

This behavior is similar to the gambler who makes a series of larger bets in hopes of breaking even.

Source: CFA Institute

5. You remember your past mistakes.

How you trade in the future is often affected by the outcomes of your previous trades.  

For example, you may have sold a stock at a 20% gain, only to watch the stock continue to rise after your sale. 

 And you think to yourself, "If only I had waited."  

Or perhaps one of your investments fall in value, and you dwell on the time when 

you could've sold it while in the money.  These all lead to unpleasant feelings of regret. 

Regret minimization occurs when you avoid investing altogether or invests conservatively because you don't want to feel that regret.

Source: CFA Institute

6. Your risk tolerance changes with the direction of the market.

Image: Flickr

Your ability to tolerate risk should be determined by your personal financial circumstances, 

your investment time horizon, and the size of an investment in the context of your portfolio. 

 Frame dependence is a concept that refers to the tendency to change risk tolerance

 based on the direction of the market. 

 For example, your willingness to tolerate risk may fall when markets are falling.  

Alternatively, your risk tolerance may rise when markets are rising.

This often causes the investor to buy high and sell low.

Source: CFA Institute