Abstract from Investment Madness by John R. Nofsinger
In order to operate in the financial markets, it is crucial to understand the investor’s psychology.
Every human being is influenced primarily by his perception of things at a given moment. Human memory stores some images of this perception, even if it is imperfect, altered by emotions at the time of storage or recall.
We analyze here a number of emotions that have a significant impact on the investor’s decision: procrastination, overestimation, staffing effect, status quo tendency, attachment tendency, habitual tendency.
The procrastination is the tendency to delay an action by fear or laziness to face reality. This attitude stems from the confusion stemming from the overabundance of information available, from their internal contradictions and from the lack of certainties. The procrastination is also justified by a lack of energy.
The overestimation of its capacities develops with experience, contrary to most human psychological tendencies. This attitude arises from an illusion of knowledge, which arises from the overabundance of information. In this context, we have the impression of controlling the situation, while our control capacities are largely outdated.
Illusion of Knowledge
The investor faces a torrent of information he believes to be mastering, especially in the era of the Internet and streaming media. He believes that the precision of forecasts increases with the amount of information, whereas the latter does not necessarily correspond to a better knowledge. The investor lacking skills or experience tends to seek confirmation of his ideas in the information available, even if they have unreliable or fragile bases.
Illusion of Control
The more the investor believes to control the situation, the more his confidence will be disproportionate. Several factors lead to this situation, such as predicted outcomes, familiarity with the task and repetition of an activity.
The investor tends to retain what he owns and maintain his positions rather than putting his choices into question. The trend towards the status quo is confirmed by the increase in the number of options and the magnitude of losses. The investor prefers things familiar and already processed. Yet past performance is not guaranteed future results.
The investor can be passionate about a title, consider only the positive aspects, even idealize it completely, or identify with the history of the issuer or its leaders (Apple, Amazon, etc.). It confuses the history of the title or issuer with the opportunity of investment, or is based on stereotypes. So a good company (managing large incomes, having a good reputation), is not necessarily a good investment (the stock is higher than others).
The investor avoids making decisions that he may regret later, and instead seeks to increase his pride. This double movement leads to selling winning investments too early and losers too late.
After making a gain, the investor is willing to take more risks. Like a bettor, he does not consider his profit as his. The bettors call this attitude “play with the money of the house”.
The Snake Bite
After suffering losses, the investor sins by excess of prudence. He does not want to take risks. By becoming passive, the investor also avoids any possibility of gain, bogged down in the status quo.
The catch-up effect
The investor needs to catch up, regain the lost capital, regain initial security. He will hope to raise the title and refrain from selling. The catching effect is stronger than the effect of the snake bite.
The Effect of Panurge
The effect of Panurge is to follow the herd. The majority of the market influences the psychological and emotional tendencies that are based on the reactions of the mass, rather than the rigorous analyzes.
The Effect of the Hole Pocket
Once an investment in money, time or emotion has been made, the investor will continue his effort, in a dynamic escalation, without ever admitting that his pocket is holed and that he lost his stake.
Policy makers tend to mentally place each investment in a separate account. There is no linkage between transactions, which creates a false perception of the risk that exists on a portfolio.