Behavioral biases—common tendencies that can be harmful to investment decision making—help explain why investors sometimes make poor choices. Investors who learn to combat behavioral biases may be better equipped to make decisions that can help improve their long-term investment results.
Heuristics are mental shortcuts that help us make quick decisions. Sometimes, however, heuristics may lead us astray.
Prospect Theory explains why losses hurt twice as bad as comparable gains feel good, which is why we sometimes may overreact to short-term portfolio losses.
Framing refers to the concept that the way a particular choice is presented can determine how people react to it. Consider how different people see optical illusions.
Attention response is the tendency to incorrectly estimate the frequency or severity of an event based on recent exposure to it. For example, some people may be afraid to fly after hearing of a recent plane crash.
Extrapolation is the tendency to estimate the future based on the assumption that trends will continue as they are. Reality is rarely as extreme as we can envision, yet extrapolation can result in some silly investment decisions.
Planning fallacy is the tendency to be overoptimistic in planning. Planning fallacy explains why most people overrate their own abilities.
Risk vs. return misperception is the tendency to believe that taking more risk results in more return. Remember, if risk were always rewarded with higher returns, then achieving the returns wouldn't be risky.