Managing the Mental Aspect of Investing
by Meir Statman
Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University, Santa Clara, California, and author of the recently published “What Investors Really Want” (McGraw-Hill, 2011). I spoke to him recently about mental hurdles investors face when making investing decisions.
Charles Rotblut, CFA
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Charles Rotblut (CR): In your book, you talk about how people commit cognitive errors such as confirmation errors and hindsight errors. Can you elaborate on the kinds of cognitive errors that people commit when they make financial decisions?
Meir Statman (MS): I begin with framing errors. We tend to frame trading stocks, mutual funds, and other investments as tennis played against a practice wall, where we see the ball hit the wall and place ourselves at the right spot to hit it back. But the correct frame of trading is real tennis against a player on the other side of the net. Would you play tennis when Roger Federer might be on the other side of the net if the loser pays $100,000 to the winner? So why are you trading when Goldman Sachs might be on the other side of the net? Remember, there is an idiot in every trade, and if you do not know who it is, it is likely you.
Some investors who frame the trading game correctly as tennis against a player on the other side of the net are often tripped by overconfidence. They know that the better tennis player would win, but surely they are the better player. They know that there is an idiot in every trade, but surely it is the other trader who is the idiot.
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