Anchoring is he tendency to work from a point of reference -- no matter how irrelevant that point may be. For example, you might have been looking for weeks at a stock trading for about $20. The stock drops to $10, and you conclude that it’s a screaming bargain -- never mind that the company just lost a contract that accounted for half its profits. The development doesn’t register as it should because you’re anchored to that $20 figure.
We often look only for facts that support the story we want to believe. Say you hear that Peru’s is the next hot stock market. You may find that the country’s economy is growing like gangbusters, but so is its inflation rate. You ignore the latter fact and invest on the basis of the former because you are so intent on making a killing.
This is simply a tendency for us to value something more highly because we own it or are familiar with it. The endowment effect is one reason workers tend to overload their portfolios with their employer’s stock. One study found that employees of the largest publicly traded companies have 40% of their portfolios in their employers' stock.
Herding means following the crowd, and it’s the root of investment manias, such as the tech bubble of the late 1990s and the madness in real estate earlier this decade. Research has shown that it’s not so much that we decide to do what others are doing; it’s more that the behavior of others changes our perception of reality.
Hindsight bias boils down to a tendency to think events are more predictable than they really are. So, after our favorite team loses, we remember thinking it was going to lose, even though we were convinced during the game that it would win. Or, after we’ve lost a ton of money in, say, a real estate fund, we remember thinking that the real estate market was on the verge of crashing, even though we put money in a property fund because we thought it would keep appreciating. Revisionist history not only protects our pride, it may help us cling to the belief that certain events are predictable.
“HOT HAND” FALLACY
We are wired to see patterns where none really exist. A simple example of this is when fans think a basketball player who’s sunk a few consecutive shots will sink the next because of a "hot hand." In fact, the next shot is no more likely to fall. This is also called the gambler’s fallacy because lousy gamblers are notorious for thinking a string of coincidences -- say, the roulette ball landing on red three times in a row -- has a bearing on the future. Investors may think that often-random data, such as stock-price changes, predict the future, too.
Losing money not only stinks, it hurts -- loss is processed in the same parts of the brain that register pain. To avoid this, investors often will not sell a security that has tanked and doesn’t have any prospects for improving. To sell at that point would be to admit the loss and feel the pain.
Even though a dollar is a dollar, people often think of money in different categories, such as money for retirement, money for vacation, money for gambling and so on. This can lead to some bad decisions, such as keeping too much money in savings when it should be used to pay off high-interest-rate credit cards.
How is it that 82% of drivers believe they’re among the top 30% of drivers when it comes to safety? Simply put, most people overestimate their abilities in many things, including investing. Studies have shown that inexperienced traders, for example, are overconfident and trade too often, thus lowering their returns.
We tend to put more weight on things that are fresh in our mind. In investing, this can have a snowball effect when a short period of rising stock prices spurs more people to jump in the market, which pushes up prices further. As times when the market was rocky become a distant memory, stocks seem less risky, and we invest yet more.