Reading Between the Lines
By Scott Medintz

The new science of behavioral finance can help investors understand
why they make mistakes - and how to prevent the next one. Investing
mistakes, like most things we do, have both immediate causes and more
fundamental ones. Didn't do your homework on a stock that tanked soon
after you bought it? Your more fundamental error may have been
crediting previous lucky moves to skill, and thereby grossly over
estimating your investing abilities. In fact, psychological factors
lurk behind many, if not all, common investor slip-ups - so much so
that a whole academic discipline called behavioral finance has
developed to study them.

What behavioral finance researchers have found over the past 30 years
or so is that the psychological processes that serve us well in many
life circumstances often mislead us in the financial realm. Recognize
the processes - so you can catch yourself before falling into these
psychological traps - and you'll make better financial decisions,
these experts say. Interested? Here's a thumbnail guide to investors'
psyches:

We all practice "mental accounting." Whether or not you realize it,
you probably have a tendency to categorize and treat money differently
depending on where you got it, where you keep it or how you spend it.
Sometimes that's good: Funds that have been earmarked for a child's
college account, for instance, should be considered untouchable. Other
times it's not so good: People tend to treat a windfall - whether it's
a bonus, tax refund, gift or inheritance - more frivolously than they
treat other money.

And sometimes, mental accounting simply defies logic. Research has
shown, for example, that people will spend more money using a credit
card than they will using cash - even for the very same item. It
sounds ridiculous, and it is ridiculous - but the studies are pretty
irrefutable. In one landmark experiment, two MIT professors auctioned
off some highly desirable Boston Celtics tickets (this was during the
Larry Bird era), allowing half the bidders to pay by credit card while
the others had to pay cash. The average credit-card bid was twice the
average cash bid.

The solution? Ask yourself whether you'd spend (or invest) the money
in question if it came from another mental account. If the answer is
no, don't do it.

We hate losing money even more than we like getting it. This "loss
aversion," as the pros call it, makes us go to great lengths to avoid
losses, sometimes to our financial detriment. One example: People are
often overly conservative, investing in, say, fixed-income vehicles to
the exclusion of stocks (which are riskier in the short term but
historically have offered higher returns over the long run).

Or we'll do foolish things to avoid finalizing and accepting losses
that have already happened - a phenomenon many of us know as throwing
good money after bad. So we'll spend hundreds of dollars to fix an old
car not because it makes economic sense, but because we've already
spent a lot on it. Or we'll hold on to a lousy stock not because we
think it's undervalued and will go back up, but because we can't deal
with the fact that the stock was a bad choice. On the flip side, we
often sell winning stocks not because we believe they've hit their
market top but because we want to eliminate the possibility of future
loss.

If you think you're immune, you're probably wrong. A 1998 study of
actual investment accounts shows that investors are not only more
likely to sell stocks that had gone up than those that had gone down,
but also that the stocks investors do sell tend to outperform those
they keep.

Sorry, but you're not quite as smart as you think. There's now hard
research indicating that a majority of us assume that we are more
skillful than we really are, especially with regard to our investing
ability. Why? The reasons are numerous, ranging from so-called
hindsight bias - the widespread tendency to believe, when looking back
on a past event, that we "knew it would happen" - to basic
misunderstandings about probability. A majority of investors, for
example, think they have a better than average chance of beating the
market - a proposition that's extremely unlikely. (Thomas Gilovich and
Gary Belsky, whose book Why Smart People Make Big Money Mistakes - and
How to Correct Them is a good introduction to behavioral finance, call
this the "Lake Wobegon effect," after Garrison Keillor's fictional
town where "all the children are above average.") This misconception
is particularly prevalent in today's frothy market, with so many
popular stocks having made spectacular gains.

What's wrong with being overly confident? Well, the dangers of hubris
have been documented since antiquity, but recent research by
University of California at Davis professor Terrance Odean puts a new
spin on the theme: The more confident investors are, the more often
they trade, and the more often they trade, the lower their investment
returns.

Makes you wonder, doesn't it?