We use mental shortcuts (heuristics) to make decisions rapidly. These work in many circumstances, but when it comes to investing, they can be a major handicap, giving rise to "cognitive biases".Key examples include the following:
Anchoring: the tendency to "anchor" to a piece of data we are exposed to while making a decision, regardless of pertinence. For example, in a 1974 study, Kahneman and Tversky asked subjects to write down the last three digits of their phone numbers, multiplied by 1,000. They were then asked to make estimates of house prices. The higher the phone number, the higher the estimate. In investing, anchoring can, for example, tempt you to buy a stock that has fallen after a profit warning, because you have anchored'' to its previous price and see it as a bargain, disregarding the deterioration in its fundamentals.
Framing: this refers to the fact that people often draw different conclusions from the same underlying information, depending on how it is presented, or "framed" (which is entirely at odds with the "rational actor" theory of efficient markets). Again, this was formalised by Kahneman and Tversky in a 1979 research paper on "prospect theory", which tries to model how people make decisions involving probability in the "real world" as opposed to the idealised economic world.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Loss aversion: the pair also found that individuals suffer from "loss aversion" we feel the pain of losses roughly twice as acutely as we enjoy the pleasure from gains, which goes some way to explaining why "framing" information on decisions in terms of risks rather than rewards can alter our reported preferences, even if the underlying data is the same.
-
How to find lost pensions, savings or investmentsLosing track of money is easy to do when moving house or changing jobs so if you’ve lost touch with your cash, we outline some simple steps to find lost pensions, investments, savings accounts and Premium Bonds
-
Frasers Group 'is a rare retail gem in a battered sector'Opinion Frasers Group is shunned for a reason, but brave investors should buy in now, says Jamie Ward
