How Powerball and Psychology Can Make You a Better Investor

If you weren't the lucky jackpot winner this weekend, don't be too upset. Sure, the Powerball lottery reached a whopping $600 million, the second-largest payout in U.S. lottery history. However, the odds of winning this record pot were about 1 in 175 million. With such a slim probability of winning, it's a wonder that anyone played at all. Yet thousands of people stood in line to purchase Powerball tickets ahead of the weekend draw -- buying around 80% of all possible lotto combinations, according to lottery officials.

With a record Powerball weekend now behind us, let's take a closer look at how understanding the lottery and psychology can make you a better investor.

Behavioral Finance 101
When investing in the stock market, the idea is to buy low and sell high. Yet our psychological biases can derail this truism -- making it harder for us to make smart investment decisions. In John R. Nofsinger's book The Psychology of Investing, the author explains how to identify and avoid such mistakes. Listed below are three of the most common psychological factors that can affect our financial decisions.

1. Overconfidence
Investors who are overconfident tend to trade their positions more frequently and thus underperform the market. "Interestingly, people are more overconfident when they feel they have control over the outcome -- even when this is clearly not the case," according to Nofsinger..

Consider this: Psychologists have found that "people who choose their own lottery numbers believe they have a better chance of winning than people who have numbers given to them at random" says Nofsinger. This means that choice can also give investors the illusion of having control, which in turn leads to overconfidence.

This is important to keep in mind, particularly if you're like me and invest using an online stockbroker, such as TD AMERITRADE. AMERITRADE and other discount brokers are great because they save you loads of money on otherwise costly commission and transaction fees. However, Nofsinger argues that it's easy to become overconfident when using online brokers since you're making your own decisions as to which stocks to buy and sell and when to do so.

2. Anchoring
This is a mistake made by both rookie investors and veterans alike. Too often investors "anchor" their perceived value of a stock to its past trading price -- and as a result missing out on future gains because they were waiting to buy in at the arbitrary price that they first anchored to. Fool analyst Dan Caplinger clearly explains the pits of anchoring in his article "The Huge Mistake Apple Investors are Making."

In the article, he cautions investors to "remember that fundamental events rather than arbitrary milestones are responsible for changes in the intrinsic value of the companies you invest in." Ultimately, investors should focus less on daily movements in stock price and more on the underlying business of the company in question.

3. Risk aversion
The rules of traditional finance have long said that people make rational decisions and are risk-averse. However, buying a lottery ticket directly contradicts this assumption. In fact, if you participated in the latest Powerball festivities, then you took on a risk-to-reward ratio of 1 to more than 175 million -- quite the opposite of risk-averse, if you ask me.

The level of risk you can handle often depends on your past investing experiences. Interestingly, studies show that investors are more likely to buy high-risk stocks after cashing out of a successful position. However, this doesn't make your gamble in the riskier stock more likely to earn you a return.

Why psychology matters
Understanding how these factors influence your investing can help you avoid making careless mistakes in the future. Sure, you may not get a sudden influx of millions of dollars like you would by beating the 1 in 175 million Powerball odds. However, your chances of generating market--beating returns for years on end are firmly within your reach. I'll take those odds any day.

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Fool contributor Tamara Rutter has no position in any stocks mentioned. The Motley Fool recommends TD AMERITRADE. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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