An old Wall Street adage states that two factors move the market: fear and greed. Although true, this characterization is far too simplistic. The human mind is so sophisticated and human emotions so complex that the emotions of fear and greed do not adequately describe the psychology that affects people as they make investment decisions. Over the course of the next two weeks, we’re going to delve into this fascinating and important subject.

Few publications provide this information because traditional finance has focused on developing the tools that investors use to optimize expected return (money, cash, …?) and risk. Now, this endeavor has been fruitful, yielding tools such as asset-pricing models, portfolio theories and option pricing. Although investors should use these tools in their investment decision making, they typically do not. This is because psychology affects our decisions more than financial theory does. So what, Ben? What does this mean to me?

Unfortunately, psychological biases inhibit one’s ability to make good investment decisions. By learning about your psychological biases, you can overcome them and increase your wealth. The presentation of psychological biases will be as follows: A passive psychological bias is first described and illustrated with everyday behavior (like driving a car). The effect of the bias on investment decisions is then explained. Last, academic studies are used to show that investors do indeed exhibit the problem. Let’s get going.

Traditionally, a formal education in finance has dismissed the idea that one’s personal psychology can be a detriment in making good investment decisions. For the past three decades, the field of finance has evolved based on the following two assumptions:

People make rational decisions.

People are unbiased in their predictions about the future.

By assuming that people act in their own best interests, the finance field has been able to cook up some solid tools for investors. [First three readers to correctly identify at least three-investment tools will receive a solid prize.] Financial economists are now realizing that investors can be irrational. Indeed, predictable decision errors by investors can affect the function of the markets. (Subprime, what?) Most importantly, people’s reasoning errors affect their investing, and ultimately their wealth. Listen up, investors who understand the tools of modern investing still can fail as investors if they let psychological biases control their decisions. Stay with me (and ask questions) and you should:

•Learn many psychological biases that affect decision making.

• Understand how these biases affect investment decisions.

•See how these decisions reduce your wealth (that would suck).

• Learn to recognize and avoid them in your own life.

Examples, Ben, examples – just tell me what I need to know.

Fair enough.

In tomorrow’s edition, I will illustrate just how real these psychological problems are. Word.