Behavioral Finance and Cognitive Biases

Humans are emotional and flawed. This includes you, me and everyone. Hope, fear, greed and despair often dominate investment behavior. With some knowledge of common irrational thinking, we can inoculate ourselves and possibly recognize these flaws when they come up within ourselves. Additionally, they can be exploited if we recognize that a collective cognitive bias is causing a stock to be mispriced.

1) Loss aversion - Studies have shown that people feel twice as much pain for a loss as they do for a gain of equal amount. This tends to cause panic selling even when the fundamentals and environment remain constant.
2) Sunk cost effect - This is the belief that money spent should be considered in decision making. It shouldn't. It's gone, forget about it.
3) Outcome bias - This is the tendency to judge a decision by the outcome rather than the quality of the decision at the time it was made.
4) Recency bias - This is the tendency for people to place a greater emphasis on recent events, data and experience.
5) Anchoring - This is the tendency to use readily available information rather than hard to find information when making a decision even when the difficult information is more relevant.
6) Bandwagon effect - The Law of the Herd. Doing something because everyone else is doing it. If it's on the cover of Business Week magazine as a sure-fire winner, it may be time to sell.
7) Belief in the law of small numbers - The tendency to draw unjustified conclusions from too little information. People tend to focus to much on noise.

This list is not comprehensive but it is a good start in thinking about your investment emotions and possible flawed thinking. That's one of the great things about investing, it can teach you about yourself.

[Source - The Way of the Turtle by Curtis Faith, well written but not recommended for value investors at it deals with using a Donchian Channel trend system for commodity trading]