There is a long list of academic theories and models that attempt to explain and understand the economy and markets. While none are perfectly infallible, many nevertheless have their merits and provide important practical lessons.
One of the most exciting and fastest growing areas of research is in the field of Behavioral Finance, which seeks to understand how we approach investing by applying the lessons of psychology. While most other economic schools of thought assume that investors are rational, sensible and well informed, behavioral finance acknowledges that we are emotional beings who often exhibit impulsive, irrational and sometimes self destructive tendencies.
While a thorough and detailed review of the field is not possible in this forum, I would nonetheless like to outline some of the major findings from this area of research. Hopefully this will allow us to better understand our motivations and allow us to avoid making poor investment decisions. (For those who are interested in a more detailed review, I highly recommend the book “Behavioral Investing: A practitioners guide to behavioral finance” by James Montier).
Below are some of the more common biases we tend to exhibit as investors.
- Short term focus
Humans are highly focused on the short term, and will most often choose immediate satisfaction over long term gratification, even if the latter is objectively a more rewarding proposition. This means that we often opt to lock in small profits today rather than allowing our investments time to grow into something more substantial. Furthermore, it means we are easily scared off by short term losses even if there has been no fundamental cause for alarm.
- Herd mentality
We are all hard wired to go with the flow. None of us like to act in opposition to the general consensus, and find it much easier to behave in a way that is consistent with our peers. This means that we are easily carried away by irrational exuberance and overly sensitive to crippling pessimism. Although it has been repeatedly demonstrated that the best time to invest is during periods of great pessimism and the best time to sell is during periods of unbridled optimism, the vast majority of us do the exact opposite.
It is easy to demonstrate that most novice investors tend to fare very poorly, but this fact does little to discourage people from diving head first into the markets with little understanding or planning. We all tend to see ourselves as “above average” and assume that we will be smart enough to avoid the stupid mistakes made by others. Furthermore, when investments go our way we chalk that up to our amazing skill and insight. When the market moves against us, it is simply bad luck. This means we often fail to recognize mistakes as mistakes, and are doomed to repeat our past errors. The lesson here is to remain as realistic as possible, and don’t fool yourself into thinking that you have special abilities above that of the ordinary person.
- Heads in the sand
We all love to hear things that agree with our own opinions and reinforce our beliefs. More importantly we loathe anything that disagrees with our outlook and tend to dismiss it as unimportant, or often simply wrong. The truth is that we do ourselves a serious disservice by ignoring information purely on the basis that it disagrees with our own view. Investors who limit themselves in this way are destined to fail at evaluating events in an objective and considered fashion.
- A focus on the irrelevant
Our brains have evolved to identify patterns, and indeed this has provided us with an important survival mechanism. Unfortunately though, we are often prone to see patterns where none exist and in contradiction to what a more thorough and balanced analysis would tell us. Many people base their investment decisions on price alone, while others look to the heavens and use astrology as the basis for their decisions. Because unrelated phenomenon will inevitably align from time to time, we will most often view this as validation, and in conjunction with the previous point, will fail to consider anything that questions the assertion. Investors would do well to ignore any investment style or technique that is not strongly supported by evidence.
- I know best
Many experiments have shown that we tend to give more weight to our own experiences than we do to the experience of others, or even rigorous statistical evidence. The classic example is with someone who has smoked all their life and never gotten sick, or who has a parent who smoked 10 packets a day and lived to be 100. Despite the fact that the dangers of smoking are well established, they will disregard the facts because it doesn’t match their own experience. Similarly, if someone has lost money in the market then they believe that share market investing is a dangerous and reckless exercise. On the other hand, those that have done well recently will mistakenly believe that it is easy and relatively straightforward to make good money trading shares. The truth of course lies somewhere in between these two extremes, but few people are accepting of evidence that does not agree with their own experience.
- The endowment effect
It seems that ownership tends to drastically distort our perception of value. That is, we tend to attribute a greater than reasonable value to something purely on the basis that it is ours. This gets us into trouble when we own shares that are performing poorly. We tend to assume that the market has made a mistake, not us, and that the price will ultimately recover. Sometimes this will even cause us to buy more stock in the hope of “averaging down” our losses. Smart investors do not become emotionally attached to their shares.
We cannot change the fact that we are emotional beings, and nor would we want to. The point is that investment decisions should be driven primarily by reason and objectivity. That is, although it may be easier said than done, you should invest with your head, not your heart. The best way to do this is to establish a very clear strategy prior to entering the market. Map out in advance what it is you are looking to achieve and have a clear plan of action to respond to all likely scenarios. This way you will never be taken by surprise, and will be less likely to act irrationally and emotionally.
Make the markets work for you