The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding Investing Psychology The Effects of Behavioral Finance on Investment Choice and Bias TIM RICHARDS Creator of the Psy-Fi Blog (www.psyfitec.com) Cover image: ©iStochphoto.com/AmandaRuch ©iStochphoto.com/fatido Cover design: Wiley Copyright © 2014 by Tim Richards All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation Y ou should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 5724002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data: Richards, Tim, 1961Investing psychology : the effects of behavioral finance on investment choice and bias / Tim Richards pages cm.—(Wiley finance series) Includes bibliographical references and index ISBN 978-1-118-72219-0 (cloth) Investments—Psychological aspects Finance—Psychological aspects I Title HG4515.15.R53 2014 332.601′9–dc23 2013050096 To Skyla, Alexa, and Hallie; for being there always, as I will always be here for you CONTENTS Preface CHAPTER Sensory Finance Beating the Bias Blind Spot Illusory Pattern Recognition Superstitious Pigeons—and Investors The Super Bowl Effect: If It Looks Too Good to Be True, It Is Your Financial Horoscope: Forecasting and the Barnum Effect Uncertainty: The Unknown Unknowns Illusion of Control Stocks Aren't Snakes Herding Availability Assuming the Serial Position Hot Hands Financial Memory Syndrome Attention! The Problem with Linda Representation The Seven Key Takeaways Notes CHAPTER Self-Image and Self-Worth The Introspection Illusion Blind Spot Bias, Revisited Rose-Colored Investing Past and Present Failures Depressed But Wealthy Disposed to Lose Money Loss Aversion Anchored Two Strangers Hindsight's Not So Wonderful Deferral to Authority Emotion Black Swans Dirty Money, Mental Accounting A Faint Whisper of Emotion Psychologically Numbed Martha Stewart's Biases Retrospective Annual Returns Nudged Mindfulness The Seven Key Takeaways Notes CHAPTER Situational Finance Disposition vs Situation Beauty Is in the Eye of the Investor Angels or Demons? Merely Familiar Lemming Time Story Time Wise Crowds? Adaptive Markets George Soros's Reflexivity Grow Old Quickly Speaking Ill The Power of Persuasion SAD Investors Sell in May The Mystery of the Vanishing Anomalies Tweet and Invest Fire! The Rise of the Machines The Seven Key Takeaways Notes CHAPTER Social Finance Conform—or Die Groupthink Motivated Reasoning Polarized A Personal Mission Statement: Social Identity and Beyond Gaming the System You've Been Framed Behavioral Portfolios Dividend Dilemmas The Language of Lucre Embedded Investing Financial Theory of Mind Trust Me, Reciprocally Akerlof's Lemons The Peacock's Tail Facebooked Be Kind to an Old Person The Seven Key Takeaways Notes CHAPTER Professional Bias Mutual Fund Madness Is Passive Persuasive? Losing to the Dark Side Forecasting—The Butterfly Effect Forecaster Bias Feminine Finance Trading on a High Marriage and Money Muddled Modelers CEO Pay—Because They're Worth It? Corporate Madness Buyback Brouhaha Oh No, IPO Your Percent Self-Inflicted Trading Tax Expert Opinion? Avoid the Sharpshooters The Seven Key Takeaways Notes CHAPTER Debiasing Numbers, Numbers, Numbers Losing Momentum Mean Reversion Short Shift Diworsification Disconfirm, Disconfirm Reverse Polarization Expected Value Investing in the Rearview Mirror Living with Uncertainty Sunk by the Titanic Effect Changing your Mind Love Your Kids, not Your Stocks Cognitive Repairs Satisficing The Seven Key Takeaways Notes CHAPTER Good Enough Investing #1: The Rule of Seven #2: Homo Sapiens, Tool Maker #3: Meta-Methods #4: Be Skeptical #5: Don't Trust Yourself #6: Self-Control Is Key #7: Get Feedback A Behavioral Investing Framework Step #1: Making It Personal Step #2: Build an Investing Checklist Step #3: Write It Down Step #4: Diarize Reviews Step #5: Get Feedback Step #6: Do Autopsies Step #7: Update Adaptively The Worst Offenders Tools The Mechanics of Investing The Seven Key Takeaways Notes CHAPTER A Few Myths More Myth 1: Money Makes Us Happy Myth 2: Everyone Can Be a Good Investor Myth 3: Numbers Don't Matter Myth 4: Financial Education Can Make You a Good Investor Myth 5: I Won't Panic Myth 6: Debt Doesn't Matter Myth 7: I Can Get Percent a Year from Markets Myth 8: Inflation Doesn't Matter Myth 9: Everyone Has Some Good Investing Ideas, Sometime Myth 10: I Don't Need to Track My Results The Seven Key Takeaways Notes CHAPTER The Final Roundup Notes About the Companion Website About the Author Index End User License Agreement List of Illustrations Chapter FIGURE 1.1 The Müller-Lyer Illusion FIGURE 1.2 The Müller-Lyer Illusion as a 3D Perception FIGURE 1.3 + Sign Chapter FIGURE 7.1 Seven Stages of Behavioral Investing Framework confirmation bias corruption hypothesis dark pools earnings forecasting easy data bias fiduciary duty forecasting gender differences in investing herding idiosyncratic risk initial public offerings instant history bias losses masculinity mergers and acquisitions narratives overconfidence overoptimism price discovery regulation, professional risk-taking behavior seersucker illusion share buybacks share options survivorship bias Texan Sharpshooter Effect trading costs winner's curse women as investors Pronin, Emily Pronovost, Peter Psychophysical numbing Quantitative models Rabin, Matthew Radzevick, Joseph Rainy day fund Randi, James Random Walk Down Wall Street, A (Malkeil) Rao, Akshay Rasmussen, Louise Rau, Raghavendra Reasoning, motivated Recency effect Reciprocity Reflexivity Regression to the mean Regret Regulation, professional Reinforcement Reinhart, Carmen Reports, annual Representative heuristic Resilience Resource depletion Results, tracking Reviews, scheduling Risk Risk-taking behavior Risky shifts Ritter, Jay Rodin, Judith Rogoff, Kenneth Rosenthal, Norman Ross, Lee Roussanov, Nikolai Ruenzi, Stefan Rule of Seven Rumsfeld, Donald Russo, J Edward SAD (Seasonally Affective Disorder) Sales people Salience: about anchoring and availability and mass media attention and noise traders and overcoming Sanghani, Jay Sapra, Steven Satisficing Save More Tomorrow scheme Savor, Pavel Scammers Schneider, Lukas Schwartz, Barry Schwarz, Norbert Schweitzer, Maurice Seasonal effects Seasonally Affective Disorder (SAD) Seersucker illusion Self, future Self-control Self-enhancing transmission bias Self-esteem Self-fulfilling prophecy Self-image and self-worth affect heuristic anchoring anecdotal evidence availability Babe Ruth effect backfire effect beauty effect Black Swans blind spot bias checklists de Bondt-Thaler hypothesis December effect deferral to authority depressive realism effect disaster myopia disposition effect emotion exceptions failures forecasting fundamental attribution error hindsight bias interpretations introspection illusion loss aversion mental accounting mindfulness/mindlessness moral accounting nudge theory observer bias overconfidence overoptimism over precision psychophysical numbing regret resilience resource depletion salience self-esteem self-serving bias Self-serving bias Sensory finance anecdotal evidence attention availability Barnum effect base rate neglect blind spot bias checklists conjunction fallacy dread risk false memory syndrome financial memory syndrome forecasting frequencies, observed gambler's fallacy herding hot-hands effect ideomotor effect illusion of control illusory pattern recognition information overload Linda problem mass media Müller-Lyer illusion primacy effect priming recency effect reinforcement representative heuristic salience self-control serial position effect Super Bowl effect superstitions 3D perception uncertainty visual illusions Wall Street Crash (1929) Serial position effect Serotonin Seru, Amit Seven, Rule of Share buybacks Share options Share price movements Sharot, Tali Sharpe, William Sharpshooter Effect Shefrin, Hersh Shifts, risky Shiller, Robert Shoemaker, Paul Shorting stocks Shumway, Tyler Sieck, Winston Signals Simon, David Simon, Herb Situational finance accruals Adaptive Markets Hypothesis anomalies availability Babe Ruth effect beauty premium butterfly effect butter production, Bangladeshi complementarities composition, fallacy of contrast principle conversational bias crowds, wisdom of disposition effect economic reflexivity experience fallibility, principle of familiarity fluency Halloween effect halo effect herding January effect mass media Moses Illusion narratives noise traders persuasion, power of persuasion bias reflexivity representative heuristic salience seasonal effects self-fulfilling prophecy Super Bowl effect technical analysis volatility Skepticism Skiles, Jeff Skinner, B.F Sloan, Richard Slovic, Paul Smith, Jennifer Social finance adverse selection affect heuristic asymmetry, information backfire effect beauty contest investing behavioral portfolios biases, overcoming bystander effect conformity test deceit Efficient Markets Hypothesis embeddedness fairness framing future self gaming the system group conformity group polarization groupthink incentives information asymmetry lottery-insurance behavior lying market failure memes mental accounting mind, theory of moral disengagement motivated reasoning Mutually Assured Delusion principle personal investing mission statement reciprocity reflexivity self-enhancing transmission bias self-fulfilling prophecy social identity stock market bubble formation model stock price movements trust used car market Social identity Social media Social networks Söderlind, Paul Song, Hyunjin Soros, George S&P 500 stocks Space Shuttle Challenger Space Shuttle Columbia Spinoza, Baruch Spitzer, Elliott Stapel, Diederick Stark, David Statman, Meir Staunton, Mike Staw, Barry Steinmentz, Julia Stewart, Martha Stigler, George Stock buybacks Stock dividends Stock market bubble formation model Stock market participation Stock options Stock price movements Stocks, shorting Stock tips Stoffman, Noah Stoner, James Arthur Finch Storytelling Stracca, Livio Strahilevtz, Michal Subrahmanyam, Avanidhar Sullenberger, Chesley Summary review forms Sunder, Shyam Sunk cost fallacy Sunstein, Cass Super Bowl effect Superstitions Surowiecki, James Survivorship bias Svenson, Ola Talib, Nassim Nicholas Teachable moments Technical analysis Temptation, resisting Tetlock, Philip Texan Sharpshooter Effect Thaler, Richard Thatcher, Margaret Theory of mind Thinking, superstitious Thorndike, Edward 3D perception Tikkanen, Henrikki Time, taking Tip sheets Titanic effect Titman, Sheridan Tools, limitations of Tracking results Trading, automated Trading costs Traffic safety Trust Tversky, Amos Twitter Unbelieving Uncertainty: about herding and living with salience and time constraints and United Kingdom politicians Unsystematic risk Updating adaptively Used car market Utkas, Steven Vaccination Validity, ecological Value, expected Vayanos, Dimitri Visual illusions Vohs, Kathleen Volatility Wall Street Crash (1929) Wang, Kevin Wason Rule Discovery Test Weather forecasting Weber, Elke Weber, Martin Weick, Catherine Welch, Ivo Whitson, Jennifer Williams, Kipling Willis, Lauren Wilson, M Scott Wilson, Timothy Winner's curse Wisdom of crowds Wiseman, Richard Women as investors Zahavi, Amotz Zajonc, Robert Zak, Paul Zeng, Xiao-Jun Zhu, Ning Zweibel, Peter WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA ... our customers' professional and personal knowledge and understanding Investing Psychology The Effects of Behavioral Finance on Investment Choice and Bias TIM RICHARDS Creator of the Psy-Fi Blog... instincts and they give us some clues about how our brains interpret information about the world In Western cultures, one of the most common illusions is the Man in the Moon effect: the perception of. .. theorizing on the basis of the data We'll see patterns where none really exist, we'll extrapolate on the basis of these illusory patterns, and we'll then wonder why we've lost a ton of money People