Tuesday, 17 July 2007

Cognitive bias

In behavioural finance, they talk about cognitive bias. These are reasons why normally smart people do daft things when investing/trading, etc. One of these that I keep falling for is called, "the disposition effect". This is where you try to lock in gains but let losses run. I'm okay at letting gains run, so thats half the battle but I still let losses run, rather than cut them off at my planned stop loss point.

There are several other cognitive biases which are quite interesting. Amongst these are:
  • Loss aversion - where we'll do more to avoid loss than make a gain (see http://bettrading100to100000.blogspot.com/2007/06/why-do-we-act-like-idiots.html)

  • The sunk cost effect - money spent is given more value than future money

  • Disposition effect (just mentioned)

  • Outcome bias - ons by outcome rather than quality of decision at time it was made

  • Recency bias - where recent information/experience is weighted more strongly than earlier infomation/experience.

  • Anchoring - Relying too heavily on readilly available information

  • The band wagon effect - Believing things because many other people do.

If anyone is interested in these, I can go into more detail in a future post.

A good book that covers these is:

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