From the July 2005 issue of Investment Advisor • Subscribe!

Defining Behavioral Finance Terms

Anchoring. The tendency of investors to become attached to a specific price as the fair value of a holding.

Attachment bias. Holding onto an investment for emotional reasons, such as "my grandfather left me this stock."

Cognitive dissonance. The challenge of reconciling two opposing beliefs, which often results in remembering the positive parts of an experience but forgetting the negative.

Confirmation bias. The natural human tendency to accept any information that confirms our preconceived position or opinion and to disregard any information that doesn't support that preconceived notion.

Fear of regret. The tendency to take no action rather than risk making the wrong one, which often causes an investor to hold onto a stock that's losing value, because if they sold and it rebounded they'd feel even worse.

Hindsight bias. The 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not.

Inappropriate extrapolation. The tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely.

Mental accounting. This entails looking at sums of money differently, depending on their source or the intended use.

Outcome bias. The tendency to make a decision based on the desired outcome rather than on the probability of that outcome.

Overconfidence. This is the tendency to place too much emphasis on one's own abilities. It often works hand in hand with confirmation bias.

Prospect theory. Originally developed by Daniel Kahneman and Amos Tversky, it describes the different ways people evaluate losses and gains. Their research found that losses have a much greater negative impact than a commensurate gain will have positive.

Self-affirmation bias. The belief that when something goes right, it's because you were smart and made the right decision. If it doesn't work out, it's due to someone else's fault or simply bad luck.

Status quo bias. The tendency of investors to do nothing when action is actually called for.

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