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How Thinking
Affects Investing

Summary of Heuristics and
Cognitive Biases

We have noted that to be a successful investor requires us to fulfill the following four requirements:

1. We must know what we are doing.
2. We must make good decisions.
3. We must think rationally.
4. We must be lucky.

Most people, however, are poor investors because they make decisions primarily to avoid emotional discomfort. This is because their thinking patterns are unconsciously influenced by heuristics and cognitive biases.

In this section, I am going to summarize the important ideas we have covered in this essay. I will then show you a simple way to apply this knowledge to become a successful, rational investor.

HEURISTICS are mental shortcuts that underlie our decision-making processes. We use heuristics many times a day to help us make good decisions quickly, often with minimal information. However, when we apply heuristics to the stock market — which is much different from everyday life — they often lead us astray.

COGNITIVE BIASES are powerful patterns of thinking, mostly irrational, that tend to always lead us astray.

In both cases, we are generally not aware that we are applying heuristics or cognitive biases to our decision making, which means it is difficult to recognize and correct the source of poor results.

Here is a summary of the heuristics and cognitive biases, along with the Rules of Investing you and I have discussed in this essay.

1. False Analogies to the Physical World

Interpreting investment information, such as graphs, as if they were describing phenomena in the physical world. This leads us to assume that stock prices act as if they are following the laws of gravity and inertia.

Harley's Rule of Investing #1: Your intuition cannot predict what a stock will do.

2. Representation Bias

Assuming that similar circumstances will lead to similar outcomes. This leads us to assume that the past can predict the future.

Harley's Rule of Investing #2: When you are investing, the past does not predict the future.

3. Loss Aversion

Experiencing more satisfaction from avoiding a loss than from acquiring a similar gain. This leads us to make decisions because of the fear that we will suffer emotionally if we sustain a loss.

Harley's Rule of Investing #3: The most expensive tuition is what you end up paying the market to teach you how to take a loss.

4. Endowment Affect

Placing a higher value on something we own, compared to how we would value it if we didn't own it. This makes it difficult for us to sell our holdings, even when it is in our best interests to do so.

Harley's Rule of Investing #4: The stock doesn't care who owns it.

5. Disposition Effect

Waiting too long to take losses or to moving too quickly to realize gains. Over time, this causes us to increase our losses and decrease our gains.

Harley's Rule of Investing #5: Ignore what you feel; buy and sell when it makes sense.

6. Sunk-cost Effect

Refusing to acknowledge that money that can never be recovered is gone forever. This makes it difficult to abandon a misguided plan, when we have already spent money on it.

Harley's Rule of Investing #6: Once money is gone, you can't get it back — so don't try.

7. Anchoring

Relying on only one specific item of information (an anchor) when making a decision, for example, the price that we paid to acquire a stock. Anchoring makes it difficult to analyze a situation logically, independent of previous costs or gains.

Harley's Rule of Investing #7: The stock doesn't care what you paid for it.

8. Confirmation Bias

Remembering and interpreting information in a way that tends to confirm what we already believe. This severely limits our ability to make independent, rational decisions.

Harley's Rule of Investing #8: The market doesn't care what you believe.

9. Cognitive Dissonance

The mental discomfort caused by holding multiple contradictory ideas related to a belief or a desire. This discomfort is especially pronounced when our actions do not match our beliefs. Cognitive dissonance often occurs when we encounter information that indicates that a previous decision may not work out as well as we had hoped. This leads us to reduce our discomfort by ignoring or discrediting the new information.

Harley's Rule of Investing #9: It is a lot easier to be honest with other people than it is to be honest with yourself.

10. Bounded Rationality

The realization that our potential to make the best possible choices will always be limited by our information, our ability to think rationally, and the finite time we have to make decisions.

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