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Sunday, July 03, 2005

The Psychology Behind Common Investor Mistakes (via The Big Picture)

Classical finance theory assumes that investors are purely rational (i.e. calculate the costs and benefits, risk and return, etc... in a completely dispassionate manner). On the other hand, followers of the "behavioral finance" camp take an alternate tack: they bring in the possibility that investors act like ,well, normal people. In other words, they assume that investors could be prone to things like cognitive biases, overconfidence, short-sightedness, and so on.

Barry Ritholtz at the Big Picture examines the implications of this approach for investors. He looks at the psychology behind investor mistakes, and shows how six common errors of perception and judgment can hurt investment performance. In short, they are :

  • Overconfidence
  • Fear of regret/pain of regret
  • Cognitive dissonance
  • Anchoring
  • Representativeness
  • Myopic risk aversion
It's well worth reading - click here for the whole thing.

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