Introduction to Psychology and Investing
Behavioral finance shows us many ways in which we are not always rational investors, despite what we think. Here are several examples.
- Selective Memory
- Loss Aversion
- Sunk Costs
- Confirmation Bias
- Mental Accounting
- Framing Effect
Successful investing is hard, but it doesn’t require genius. In fact, Warren Buffett once quipped, "Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one’s own psychological weaknesses.
Over the past 20 years, psychology has permeated our culture in many ways. More recently its influences have taken hold in the field of behavioral finance, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.
Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market.
In this lesson, we’d prefer to focus on how the insights from the field of behavioral finance can benefit individual investors. Primarily, we’re interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.
Some insights behavioral finance has to offer read like common sense, but with more syllables.