Mistakes We Make in Our Investment

Emotion is a great thing! It is a monitor to your inner feeling. Being emotional, either happy or sad, is a way to express yourself. It is essential for a human to have emotion because emotion makes us human. However, emotion is our worst enemy in financial market. We should always remain emotionless when dealing with financial market.

Why?

When we pick the stock right, we feel proud of our stock picking skills.
When we pick the stock wrong, we regret it and look for excuse to make us feel better.
We regret for missing the "right" time to buy/sell the stock.
We celebrate for not buying (selling) a losing (winning) stock.


With all these mixed feelings, we tend to make more errors (mistakes) and judge less rationally. Typically errors we made are:

1. Framing Error
Framing error is the result of getting the wrong understanding/direction at the starting point.

Example: You get stock information from a research house, which you think it is unique. In fact, you know nothing more than anybody else.

2. Representativeness Error
Representativeness error is the result of interpreting a small number of samples as the truth, which in fact, it does not represent the truth.

Example: You buy a fund because the manager of the fund has beaten the market six years consecutively. Beating the market six years consecutively is a small number of samples. The "law of large numbers" says that if given the sample is huge enough, the average result should be the expected value. In another word, if you toss the coin for 1000 times, you should be getting 50% of head, 50% of tail. But if you toss the coin for 6 times, you could get 6 heads 0 tail, although the chances are 1/64. So back to the fund manager, he can, by luck, beat the market 6 years and lose all your money the next year.

3. Availability Error
Availability error is the result of interpreting only the information that is already in your mind, and ignoring what is not.

Example: You see only all the winning funds through advertisements, without realizing all other losing funds. This makes you believe that winning funds are available all the time. Same goes to casino strategy: Slot machines make noise only when you win and they give frequent small wins to the players, making the illusion that you can win all the time and you are so close in winning if you lose.

4. Confirmation Error
Confirmation error is the result of searching for information to confirm your hypothesis, ignoring the evidence that contracts the hypothesis.

Example: You follow your own strategy and buy a stock because you expect to the price will increase. And it does. Then you confirm yourself that your strategy is correct. But if the price fells. You look for information to blame or neglect it as disconfirming evidence.

5. Hindsight Error
Hindsight error is is the inclination to see events that have already occurred as being more predictable than they were before they took place. In another word, because you can see the past clearly, you think you have a similar ability to tell the future.

Example: You think you expect the market will crash in 2008. But in reality, you suspect that the market is possible to crash and at the same time, it is possible to zoom. But since the market crashed in 2008, you think you are correct and tend to apply the same strategy in the future to avoid another market crash.

6. Extrapolation Error
Extrapolation error is the result of extrapolating past data to interpret what is going to happen in the future.

Example: Because the prices of house have always been increasing, you think that buying house is the best investment as the house price will always increase. In 2007, it proves you wrong!

7. Unrealistic Optimism/Overconfidence
Unrealistic Optimism/Overconfidence is the result of not understanding the risk enough or overestimate your ability.

Example: You think you knows more than others. In fact, you are just overestimating yourself.


8. Illusion of Control
Illusion of control is the result of believing that you have the ability to control the market.

Example: You think you can control your spending and saving each month when you receive your monthly wage. But are you really able to control your spending?

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In conclusion, being emotional is the reason why we make mistakes. We can only avoid these errors when we realize we are making these mistakes and understand why we are making these mistakes. So stop being emo!!

p/s: The plot summary draft of Project Z is completed. And I am working on my script of Project Z. Stay tuned!