Saturday, November 10, 2007

This experiment also applies to investing and fantasy football

Read this article about decision preferences - and how our evaluations of our decisions change our preferences after we make decisions.

The general idea is that we have cognitive process in place to reinforce the idea that the decision we made is better than we initially thought it was, and in the case of purchases as a result we value what we currently have more than we would value it if we didn't have it.

In fantasy football, I think it explains why there are so few player trades in my league. In my league hardly anyone wants to trade because they value their own players too highly. Very few fair trades can be found that are agreeable to both parties.

It can manifest itself as follows:
A. Let's say I have Shaun Alexander on my team. If I want to trade Shaun Alexander for another team's Lamont Jordan, the trade gets rejected.
B. However, if the situation was exactly reversed and I had Lamont Jordan and wanted to trade for Shaun Alexander, that trade would also be rejected.
C. Neither version of the trade will be accepted. Either Alexander > Jordan or Jordan > Alexander, but it seems in our league it depends on which one is on your team. One of the trades has to be better than the other.

In investing, I think it helps explain why we may tend to have a better opinion of our own holdings than the market overall has, and why we might hold onto a loser too long - or do what I've been doing recently and average into a stock that is dropping. In the past I've found this is not a good practice, but as we've seen I sometimes cant help myself because I've convinced myself of the value of a current holding. These psychological experiments in the story show that simply by making a decision to buy a stock I am also making a decision to overvalue that stock.

Knowing that this effect is in play can at least help us understand our thinking and control against these counterproductive tendencies.

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