Sunday, December 03, 2006

Factors that Lead to Poor Investment Decisions

An article on psychological factors that can interfere with an individual's investment decision making is contained on the free content portion of the American Association of Individual Investors website.

The factors noted below are discussed in more detail in the article.

    Decision-Making Biases

  1. Availability: Drawing conclusions based only on vivid and recent information.

  2. Irretrievability: Failing to think beyond a preconceived notion.

  3. Presuming associations: Assuming certain associations exist with no real evidence.

  4. Confirmation trap: An unconscious search for supporting evidence that the right decision has been made, while ignoring evidence that a bad decision was made.

    Measurement Biases

  5. Sample size insensitivity: Reaching a conclusion based on a small sampling of information that does not truly represent the complete situation.

  6. Ignoring regression to the mean: Not recognizing that above- or below-average results won’t necessarily continue forever.

  7. Conjunctive and disjunctive events bias: Mis-estimating the likelihood that certain events will occur when those events must take place for a particular outcome to occur.


  8. Insufficient anchor adjustment: Assuming an outcome of an event will be exactly the same as the outcome of a similar prior event without examining differences.

  9. Hindsight: Evaluating a judgment after an event has played out and with perfect knowledge of the outcome.

  10. Positive illusions: A tendency toward overly optimistic views of things rather than a realistic assessment.

    Risk-Taking Biases

  11. Avoiding uncertainty: A preference for stability rather than uncertainty.

  12. Asymmetry of risk tolerance: Investors are risk-averse with regard to gains (preferring to sell “winners” and ensure the gain) but risk-takers when it comes to losses (preferring to hang on to “losers”).

  13. Regret avoidance: Investors tend to feel more regret toward committed actions that have turned out badly rather than omissions that could have turned out favorably.

  14. Internal escalation of commitment: The tendency of an investor to increase the support of their initial decision over time.

  15. Competitive escalation: The tendency of some investors to view competitors’ actions or other investors’ collective actions as validating an investment idea.

15 Short-Cuts and Biases that Lead to Bad Investment Decisions
Paul S. Szczygiel
AAII Commentary
American Association of Individual Investors

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