The Courage of Misguided Convictions

TLDR

Modern financial economics assumes extreme rationality, yet systematic deviations from rational behavior are observed, prompting behavioral finance to incorporate these human departures into market models. The study identifies two investor mistakes—excessive trading and the tendency to hold losing positions while selling winners—and attributes them to psychological origins. Overconfidence drives excessive trading, while regret avoidance leads investors to cling to losing holdings.

Abstract

The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, people's deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second.