PSYCHOLOGY OF INVESTING by Matt Ingram Invest Ed® All Rights Reserved Oklahoma Securities Commission June 2017

Two Choices Suppose you could purchase one of two different investments for $1. The payoffs for these investments depend on one roll of a 6-sided die. Investment One: If you roll a 1 through 3, you get $1. If you roll a 4 through 6, you get $2. Investment Two: If you roll a 1 through 5, you get $0. If you roll a 6, you collect $12. Which would you purchase and why?

Searching for Alpha Original research, a new approach Beating the market is difficult. Alpha: the holy grail Alpha: the return to a portfolio in excess of the compensation for risk The idea is that if Portfolio A and Portfolio B have the same risk but A outperforms B, Portfolio A has a better manager.

The Role of Psychological Biases If you don’t have access to better information and you don’t have a better model, then you need a psychological advantage. Most investors fall victim to certain biases and behaviors that cause them to underperform the general market.

Investor Mental Behavior Warren Buffett Success in investing does not correlate with IQ once you’re above the level of 125. What you need is the temperament to control the urges that get other people into trouble. Buy when everyone else is selling. Be fearful when others are greedy; be greedy when others are fearful. Contrarians tend to outperform the crowd. 5

Behavioral Issues Prospect theory We “feel” losses more than gains. Self-attribution bias Extrapolation bias Confirmation bias: “Good news, bad news” Regret Avoidance 6

Overconfidence Are you a good driver? Compared to the drivers you encounter on the road, are you above average, average, or below average? 82% usually answer above average. Investors were polled. What will the market earn over the next 12 months? 10.3% What will your portfolio earn over the next 12 months? 11.7% 7

Overconfidence, part 2 More confidence, more trading More trading leads to lower return. High returns one month lead to high turnover (trading) the next month. Wall Street analysts who were the most accurate forecasters began to deviate from the consensus in a bad way. 8

Other Behavioral Issues House-money effect Snake-bitten investors Trying to break even, traders tend to get more aggressive during losing days. Why do our emotions change with gains or losses, and how does it cloud our judgment? You got a bonus of $100,000 versus $100,000 inheritance from parents. What do you do with the money? 9

Lynch’s Most Dangerous Things People Say About Investing If it’s gone down this much already, how much lower can it go? If it’s gone this high already, how can it possibly go higher? Eventually they always come back. It’s always darkest before the dawn. When it rebounds to where I bought it, I’ll sell. Look at all the money I lost; I didn’t buy it! 10