Investment Madness: How Psychology Affects Your Investing...And What To Do About It

190 Pages·2001·8.38 MB·English

by  John R. Nofsinger

InvestMadness-00 Fnt 6/1/01 3:22 PM Page i
WHAT THE REVIEWERS SAY
Had more traditional finance professionals been reading the psychology lit-
erature and/or taken the early writings in behavioral finance more seri-
ously, the recent extreme volatility and overpricing in certain market
sectors might have been ameliorated,or at least,better understood.
This book is a must read for everyone interested in better understand-
ing how people,and thus markets,function.
—Linda Martin,Arizona State University
I found John Nofsinger’s book loaded with common sense advice!
Personally,it helped me to let go ofbad investments and move on to logical
versus emotional choices.
—Holly Roge,Information Systems Consultant
Investment Madness provides great insight into how the way we think
impacts how we invest.A must read for all investors!
—Dr.Brian Prucyk,Marquette University
Investment Madness is an extremely insightful book.An absolute read for
the beginning or experienced investor.I’m often asked by my clients for rec-
ommendations on books about investing.This will be #1 on my list!
—E.Scott Tinder,Financial Advisor,American Express
A new perspective on investing that will benefit professionals and the indi-
vidual investor!
—Dr.Jerome A.Mahalick,CEO,Asset Management for Professionals
Every investor thinks he or she can beat the market. In fact, as this book
shows, most don’t. Sometimes funny, sometimes frightening, John
Nofsinger’s analysis of the psychological traps into which investors fall
should be required reading for anyone thinking of venturing onto Wall
Street.
—Morgan Witzel,Editor-in-Chief,Corporate Finance Review
InvestMadness-00 Fnt 6/1/01 3:22 PM Page ii
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InvestMadness-00 Fnt 6/1/01 3:22 PM Page iii
Investment Madness
How Psychology Affects Your
Investing…and What to Do About It
InvestMadness-00 Fnt 6/1/01 3:22 PM Page iv
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Investment Madness: How Psychology Affects Your Investing…
and What to DoAbout It
InvestMadness-00 Fnt 6/1/01 3:22 PM Page v
Investment Madness
How Psychology Affects Your
Investing…and What to Do About It
John R. Nofsinger
Washington State University
An Imprint ofPEARSONEDUCATION
London • New York • San Francisco • Toronto
Sydney • Tokyo • Singapore • Hong Kong • Cape Town
Madrid • Paris • Milan • Munich • Amsterdam
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Library ofCongress Cataloging-in-Publication Data
Nofsinger,John R.
Investment madness :how psychology affects your investing—and what to
do about it / John R.Nofsinger.
p.cm.—(Financial Times Prentice Hall books)
Includes bibliographical references and index.
ISBN 0-13-042200-2 (case)
1.Investments—Psychological aspects. 2.Investments—Decision making.
I.Title. IISeries.
HG4515.15 .N64 2001
332.6'01'9—dc21
2001024614
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TABLE OF CONTENTS
INTRODUCTION
xi
Chapter 1 Your Behavior Matters! 2
Why Haven’t I Heard ofThis Before? 4
A Simple Illustration 4
Prediction 5
Behavioral Finance 8
The Investment Environment 8
Endnotes 10
1 NOT THINKING CLEARLY
11
Chapter 2 Overconfidence 12
Becoming Overconfident 14
Illusion ofKnowledge 14
Illusion ofControl 18
Recipe for Disaster? 19
Endnotes 20
Chapter 3 Overconfidence and Investing 22
Overconfidence: A Case Study1 23
Overconfidence and Trade Frequency 25
Gender Differences 25
Trading TooMuch 26
Overconfidence and Risk 28
Overconfidence and Experience 29
Mutual Funds 30
Overconfidence and the Internet 30
Summing Up 31
Endnotes 32
Chapter 4 Status Quo—Or What I Own Is Better! 34
Endowment Effect 35
Endowment and Investing 36
Status Quo Bias 37
Attachment Bias 40
Overcoming These Biases 41
Endnotes 43
INVESTMENT MADNESS: How psychology affects your investing…and what to do about it VII
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2 EMOTIONS RULE
45
Chapter 5 Seeking Pride and Avoiding Regret 46
Disposition Effect 47
Do We Really Sell Winners? 49
Selling Winners Too Soon and Holding Losers
Too Long 51
The Disposition Effect and the Media 51
Avoiding the Avoiding ofRegret 52
In Summary 54
Endnotes 55
Chapter 6 Double or Nothing 56
House-Money Effect 57
Snake-Bit (Risk-Aversion) Effect 58
Break-Even Effect 59
Would You Buy This IPO? 60
The Tech Bubble 62
Endnotes 64
Chapter 7 Social Aspects of Investing 66
Sharing Investment Knowledge 67
Moving with the Herd 68
Speed Is ofthe Essence (Not) 69
Investment Clubs 71
Beardstown Ladies 71
Investment Club Performance 72
Investment Clubs and Social Dynamics 73
Summing Up 74
Endnotes 75
3 FUNCTIONING OF THE BRAIN
77
Chapter 8 Mental Accounting 78
Mental Budgeting 80
Matching Costs to Benefits 80
Aversion to Debt 82
Sunk-Cost Effect 82
Economic Impact 84
Mental Accounting and Investing 84
Endnotes 86
VIII INVESTMENT MADNESS Table of contents
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Chapter 9 Mental Accounting and Diversification 88
Mental Accounting and Portfolios 89
Risk Perceptions 91
Risk Perception in the Real World 96
Building Behavioral Portfolios 96
Summing Up 98
Endnotes 99
Chapter 10 That’s Not the Way I Remember It 100
Memory and Investment Decisions 102
Cognitive Dissonance 103
Cognitive Dissonance and Investing 104
Cognitive Dissonance and the Steadman Funds 105
Memory and Socialization 106
Reference Points 107
Summing Up 109
Endnotes 110
Chapter 11 What I Know Is Better 112
Representativeness 113
Representativeness and Investing 114
Familiarity 116
Familiarity Breeds Investment 117
Familiarity Breeds Investment Problems 119
Endnotes 121
4 INVESTING AND THE INTERNET
123
Chapter 12 The Internet (Psycho) Investor 124
The Rise ofthe Internet Investor 125
Amplifying Psychological Biases 126
Information and Control 126
Online Trading and Overconfidence 128
Advertising—Increasing the Biases 129
Online Trading and Performance 130
Day Traders—The Extreme Case 130
Summing Up 132
Endnotes 133
INVESTMENT MADNESS Table of contents IX
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Chapter 13 Exuberance on (and about) the Net 134
A Rose.com by Any Other Name 135
A Bubble Burst 137
The More Things Change… 138
The Boiler Room Goes Online 140
Endnotes 143
5 WHAT CAN I DO ABOUT IT?
145
Chapter 14 Self-Control, or the Lack of It! 146
Short-Term versus Long-Term Focus 148
Controlling Ourselves 148
Rules ofThumb 148
Environment Control 149
Self-Control and Saving 150
IRAs 151
401(k) Plans 151
Self-Control and Investing 152
Self-Control and Dividends 153
Summing Up 155
Endnotes 156
Chapter 15 Battling Your Biases 158
Strategy 1: Understand Your Psychological Biases 159
Not Thinking Clearly 159
Letting Emotions Rule 161
Functioning ofthe Brain 162
Strategy 2: Know Why You Are Investing 163
Strategy 3: Have Quantitative Investment Criteria 165
Strategy 4: Diversify 166
Strategy 5: Control Your Investing Environment 166
Additional Rules ofThumb 168
In Conclusion 169
INDEX
171
X INVESTMENT MADNESS Table of contents