I have just finished a fascinating book, Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich. Traditional economics considers people as rational being, acting to optimize one's own welfare. In practice, few people really acting rationally all the time. Even well informed people have found to make many faulted financial decisions. Behavioral economics incorporates psychology and cognitive factor into consideration. It have found great insight into people decision making process.

Below are simply my notes taken from the book.

Ch.1 Mental Accounting, Richard Thaler. Statistical Regression, Sir Francis Galton, 1911 (tendency to fall back into statistical mean).

Ch.2 Prospect Theory, Daniel Kahneman, Amos Tversky, 1979. (Issue framing, e.g. loss aversion, sunk cost fallacy).

Ch.3 The Devil That You Know

Decision Paralysis - tendencies to avoid or delay action, particularly due to the fear of regret and a preference for the familiar.

• Maximizer/Satisfier - Herbert Simon, 1950s.
• Trade off contrast - choices are enhanced or hindered by the tradeoff between options, even for options we wouldn't choose anyway, Tversky, Simonson.
• Extremeness aversion - people are more likely to choose an option if it is an intermediate choice within a group, Tversky, Simonson. (so it can be manipulated by introducing extreme choice).
• Status quo basis, endowment effect - preference for holding on what you have.
• Regret aversion - avoid the pain of regret and the responsibility for negative outcomes.

Counter Measures

• Take opportunity cost into account
• Mark Twain's saying, "Twenty Years from now you will be more disappointed by the things you didn't do than by the ones you did do."

Ch.4 Number Numbness

• Neglecting the base rate - tendency to disregard or discount overall odds, Kahneman, Tversky.

Ch.5 Dropping Anchor

• Anchoring - clinging to a fact or figure or idea that may or may not have any real relevance to your judgment or decision.
• Confirmation bias/Preferential bias - once people developed bias, they tend to view new information in such a way that it supports those preferences (Edward Russo).

Ch.6 The Ego Trap

The tendency to attribute success to your ability but to attribute failure to other causes.

• Heads I win, tails it's chance, Eileen Langer, 1975
• "Expert" predicition, Tetlock
• "Hindsight bias", Baruch Fischhoff

2010.05.27 [book, investment] - comments