Determining how much to weight a recent event versus historical data or long-term trends.
Effects:
Overreaction to short-term market movements.
Misinterpreting the continuation of trends due to recent events.
Example
An investor liquidates a long-term portfolio out of panic after experiencing a week of declines while the fundamentals were sound.
How to Reduce:
• Focus on long-term investment objectives and plans.
• Use historical information for context in times of short-term events.
7. Mental Accounting
Mental accounting refers to the practice of treating money differently because of its origin, allocation, or purpose.
Effects:
• Illogical segregation of funds, thereby suboptimally allocating assets.
• Risking unnecessary amounts of "house money" - that is, amounts realized from investments.
Example:
An investor believes that the money made in a stock is "free money" and invests in highly speculative assets.
How to Overcome:
• Treat all money as a single portfolio.
• Focus on overall portfolio performance rather than individual investment performance.