Investing Psycology

1.Projecting the Immediate Past Into the Distant Future

Driving while “looking into the rear-view mirror instead of through the windshield.”--- Warren Buffett

2.Herd-Like Behavior: A “social proof” phenomenon

From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund.
• Over the same period, the average bond mutual fund returned 9.7% annually, while the average investor in a bond mutual rose earned 8% annually
– A far narrower gap than equity funds
– Bond markets are not as susceptible to bubbles and crashes

3.Misunderstanding Randomness

• Which series of coin flips is more likely to be random:
OXXXXXOXOOXOOXOOXOOX
or
OOXOXXOOXXOOXOXXOXOX

4.Commitment/Consistency

• “A study done by a pair of Canadian psychologists uncovered something fascinating about people at the racetrack: Just after placing a bet, they are much more confident of their horse’s chances of winning than they are immediately before laying down that bet.
The reason for the dramatic change is…our nearly obsessive desire to be (and to appear) consistent with what we have already done. Once we have made a choice or taken a stand, we will encounter personal and interpersonal pressures to behave consistently with that
commitment. Those pressures will cause us to respond in ways thatjustify our earlier decision•
“I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now,you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I.”
– Warren Buffett,2003 Berkshire Hathaway annual report
5.Anchoring

1.Anchoring on purchase price
– “When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored. I cost us about $10 billion [by not buying enough Wal-Mart]. I set out to buy 100 million sharers, pre-split, at $23. We bought a little and it moved up a bit and I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more,cost us a lot.” -- Buffett
2.Anchoring on historical price (or typical price)
Refusal to buy a stock today because it was cheaper last year or has a high price per share (Infosys,Crisil,Bosch)
– Refusal to sell because it was higher in the past
3.Anchoring on historical perceptions
4.Anchoring on initial data/perceptions
5.Anchoring on meaningless numbers

6.Loss Aversion

• People feel pain of loss twice as much as they derive pleasure from an equal gain

“There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish.
On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.”
.........Philip Fisher, Common Stocks and Uncommon Profits

• Failing to Buy
– Status quo bias
– Regret aversion
– Choice paralysis
– Information overload
– Hope that stock will go down further (extrapolating recent past into the future; greed) or return to previous cheaper price (anchoring)
– Regret at not buying earlier (if stock has risen)
• Failing to Sell
– Status quo bias
– Regret aversion
– Information overload
– Endowment effect
– Vivid recent evidence (if stock has been rising)
– Don’t want to sell at a loss (if stock has been falling)
– If I didn’t own it, would I buy it? Or, If the stock dropped 25%, would I enthusiastically buy more?