Whether it was mental accounting, anchoring or simply following the herd, we've all been guilty at one time or another of some of the mistakes or irrational behaviours that were highlighted in this tutorial.
Now that you know how to identify some of these "biases", it's time to apply this knowledge to your investing and - if necessary - take corrective action.
Let's hope that your future financial decisions will be a little more rational and much more lucrative!
Here's a summary of everything that we've covered:
- Conventional finance is based on the theories that describe people, mostly those who exhibit logical and rational behavior. People began to question this perspective, because there have been anomalies and events that conventional finance hasn't been able to explain.
- Three of the biggest contributors are psychologists Daniel Kahneman and Amos Tversky, and economist Richard Thaler.
- The concept of anchoring is based on the tendency we have to assign or "anchor" our thoughts to a reference point despite the fact that it doesn't have sufficient logical relevance for one to make a decision.
- Mental accounting refers to the tendency that people have to divide their money into separate accounts based on criteria such as the source and the use of the money. The amount of funds in each account also varies depending on the source and its intended use.
- Confirmation bias refers to how people tend to pay more attention to new information that confirms their own opinions and preconceived notions on a subject.
- Retrospective bias refers to when people think that a past event could have been predicted.
- Player's error refers to a misinterpretation of statistics: when someone believes that an independent and random event can influence the probability that another independent and random event will occur.
- Herding behaviour represents the preference people have for imitating the behaviours or actions of a larger group.
- Overconfidence represents a trader's tendency to overestimate his or her ability to successfully perform certain actions.
- Overreaction occurs when certain economic news is overreacted to in a way that is disproportionate to the actual impact of the news.
- Perspective theory refers to the idea that most people tend to be more sensitive to losses (in the sense that they feel more pain after a loss, compared to the amount of pleasure they would feel after an equal amount gained).