BazermanMoore

138 Chapter 8: Common Investment Mistakes
In this chapter, we will specifically: (1) apply some of the core findings from earlier
chapters to investment decisions, (2) explore the scary practice of active trading, which
became popular in the late 1990s, and (3) close with some clear, common-sense investment
advice. As you read, we encourage you to compare these insights to your own
beliefs about investing and to your current investment portfolio. Behavioral finance is,
after all, an application of basic principles to a specific decision domain. Consequently,
you will notice that this chapter is more practical and implies more specific advice than
most of the other chapters in this book.
THE PSYCHOLOGY OF POOR INVESTMENT DECISIONS
Investors love new books promising huge increases in stock-market prices. Glassman
and Hassett’s (1999) wildly optimistic book Dow 36,000, for example, received enormous
media attention. Such titles achieve their success by exploiting investor psychology.
Motivated optimism and the confirmation bias are enough to convince people with
money in the market that their investments have a bright future. This is great for the
authors who get rich from these books, but their success does not usually translate into
investing success for the books’ readers. As we have shown in earlier chapters, even
very bright people make poor decisions that cost time, profitability, and in some cases,
their financial futures.
As you read this chapter, our arguments against active investing may sound too
strong. However, the evidence is overwhelming, and it contradicts the massive amounts
of money and advice changing hands in financial markets. Investors pay high fees to
actively managed mutual funds and hedge funds, to brokers to pick stocks, and to electronic
trading companies to make frequent trades. These fees are how funds, brokers,
and companies make their money. Are all of these investors making mistakes? The
great majority of them are. As Jason Zweig (2000) warned the readers of Money Magazine,
‘‘The folks who run mutual funds have always been good at cooking up clever
ways to gouge you on fees, confuse you about performance, make you pay unnecessary
taxes and goad you into buying funds you don’t need.’’
The high rate of trading in the stock market has long been a mystery for economists.
Rational economic agents should trade very little, and certainly nowhere near as
much as real investors trade (Grossman & Stiglitz, 1980; Odean, 1999). The human
biases we have reviewed in the preceding chapters do offer some answers. And the fact
is, the financial professionals whose incomes depend on the fees their clients pay for
making trades are good at exploiting these biases in their investors. This section will
document how investment decisions are affected by: (1) overconfidence; (2) optimism;
(3) denying random events and the regression to the mean; (4) anchoring, the status
quo, and procrastination; and (5) prospect theory.
Overconfidence Produces Excessive Trading
In Chapter 2, we offered evidence that people are generally overconfident with respect
to the precision of their knowledge, beliefs, and predictions. In the area of investing,
this overconfidence can translate into a tendency to be excessively sure that you know