Aspects of Investor Psychology (Part II)

This is the second part of my weekend reading: Aspects of Investor Psychology. In the first part, the focus was on overconfidence in investor’s decision making process. The topic of this part is optimism in investing of both financial advisors and investors like you and me. Take a look at the following question:

Question 2: How good a driver are you? Compared to the drivers you encounter on the road, are you above average, average, or below average? If an acquaintance purchased a stock that later did badly, do you think of this as a mistake, or as a case of bad luck?

When I answered this question, I put myself in the average category mainly because of my short driving history (only eight years). However, if my stock pick goes sour, most likely I will blame bad luck. On the contrary, if I admit that I made a mistake, am I willing to accept the fact that I have failed to predict the outcome of my investment decision? Will I have a second thought about my knowledge and ability when I face the same circumstance next time?

With this question, the authors touched another common phenomenon in decision making: optimism. When investors are optimistc, they again tend to be biased. Overoptimism, together with overconfidence, exaggerates investors’ talents, knowledge, and their event-control ability, therefore, underestimate the possibility of a bad outcome of their financial decision. To overcome optimism in making financial decisions, the authors recommended:

  • Resist the natural urge to be overoptimistic about the courses of action you recommend for your clients. Think, for example, of things that could go wrong.
  • Because you are more likely to remember your successes, keep a list of past recommendations you made that were not successful.
  • Communicate realistic odds of success to your clients.
  • When presenting historical data to clients, resist the temptation to focus on the upside.
  • Optimists who are also regret-prone have the worst combination of traits, both for themselves and for the professionals who try to help them. Early identification of such tendencies is therefore useful.

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