Taming the Beast: Wall Street's Imperfect Answers to Making Money

Summary

• A new discipline, called behaviorism, demonstrates that emotions and human fallibility are large factors in investing decisions—contrary to the efficient market hypothesis, with its foundation on a belief in the rational investor. Behaviorism offers a list of mistakes that fallible, irrational humans often commit. The father of behavioral economics, Daniel Kahneman, developed many theories in the field. The first is that people use mental shortcuts to make judgments, and that can lead to blunders.
• Cognitive traps are abundant in investing. One is “mental accounting,” where we classify money into different strata, and thus treat it differently. Although we have ample bank funds, we will not tap them to pay off high-interest credit card balances. With “availability bias,” we take the shortcut of employing the most readily accessible information, such as a stock’s price, to make a buy decision, not bothering to dig into its fundamentals.
• Ignoring the odds and making false connections, a phenomenon called “neglecting the base rate,” is a pernicious pitfall. A five-year winning streak for a mutual fund doesn’t mean that a sixth good year is guaranteed. “Anchoring” involves using outdated or wrong information to measure value. Someone may invest in Dell, the computer maker and market laggard, by fondly recalling its glory days. A similar snare is “confirmation bias,” where you fasten onto information backing your viewpoint and ignore contradictory evidence.
• The “sunk cost” fallacy ...