In Investment Madness: How Psychology Affects Your Investing…and What to Do About It, John R. Nofsinger (’88 Elect. Engr., ’96 Ph.D. Fin.) debunks the accepted wisdom that people make rational investment decisions. They don’t. The book lays out the psychological biases and emotions that often trip up investors, impair their decisions, and consequently jeopardize their wealth.
Unlike other books on finances, this one “focuses on the reader—the investor, rather than on the stock market and investment strategy,” says the Washington State University assistant professor of finance.
While investors blame financial analysts and overhyped stocks for the depressed state of many nest eggs following the recent stock market collapse, Nofsinger says that it is the investors themselves who should shoulder the blame. The book contends that easy access to the stock market and the Internet are making investors more vulnerable than ever to their psychological biases. He clusters these biases into three categories:
Not thinking clearly. This causes investors to trade too much and take too many risks; to focus on the good traits of securities and ignore the bad signs; or to maintain the status quo and do nothing.
Letting emotions rule. Seeking pride causes investors to sell winners too soon; trying to avoid regret causes investors to hold losers too long.
Ignoring the way the brain works. Cognitive dissonance filters information, changing recollections of bad experiences and impairing an investor’s ability to properly evaluate investment choices. Associated with this is what Nofsinger calls “representativeness,” or the brain’s way of reducing complexity by taking shortcuts and judging information based on stereotypes of previous experiences. This leads investors to put too much faith in stocks that they are familiar with or that represent desirable qualities.
“By being aware of your biases and working to overcome them,” Nofsinger says, “investors are more likely to make good investment decisions, reach their investment goals, and see their money grow faster.”
He recommends five main strategies to overcome biases: 1) Know what your biases are. 2) Know why you are investing. 3) Set and stick to quantitative investment criteria. 4) Diversify. 5) Control your investment environment.
If you find these recommendations hard to follow, consider setting aside some “play money.” Set up two brokerage accounts, one containing the bulk of the wealth and the other that allows you to aggressively trade a small portion of the total.
“I can’t guarantee a specific return each year,” Nofsinger says to those who follow the book’s advice. But he does guarantee that investors who identify their biases and act to overcome them will do better than if they stick with their current ways. In addition, they are much more likely to avoid making disastrous decisions that seriously harm their wealth.
Investment Madness was “still getting media attention” six weeks after it was published, Nofsinger reports. He had conducted interviews for television with The Money Gang on CNN’s Financial News, New York Cable One, and the USAM News by Bloomberg TV on the USA Cable Network. In addition, he has been interviewed by Wisconsin Public Radio, Milwaukee Public Radio, The Wisdom Show on National Talk Radio, and Radio Free Wall Street in New York and Philadelphia. All this in addition to interviews with Forbes and Business Week, Reuters News Service, and book reviews in Kiplinger’s Personal Finance and Better Investing Magazine.
John R. Nofsinger (WSU Assistant Professor of Finance). Investment Madness: How Psychology Affects Your Investing and What to Do about it. Financial Times/Prentice Hall: 2001