Reblog: How Investor Behaviour Gets in the Way of Success
Most textbooks portray humans as self-interested people making rational economic decisions, but people often are far from rational in making investment decisions.
Behavioral economics provides insight into why humans make sub-optimal decisions, studying the impact of psychological, cognitive and emotional factors on economic and investment decisions. Two winners of the Nobel Prize in economics, Richard Thaler and Daniel Kahneman, have been recognized for their pioneering work in behavioral economics.
In awarding the Nobel to Thaler in 2017, the Royal Swedish Academy of Sciences stated, “His contributions have built a bridge between the economic and psychological analyses of individual decision-making.” Thaler’s work was instrumental in pension reform, illustrating how subtle changes in framing can lead to dramatically different consumer choices. Thaler’s research contributed to policy changes including automatic enrollment of employees in 401(k) plans and the use of target date funds as the default option for new 401(k) enrollees instead of money market funds.
Kahneman’s 2002 Nobel was awarded for findings that challenged assumptions of human rationality prevailing in modern economic theory. Kahneman’s “Thinking, Fast and Slow” summarizes decades of research and explains his theory about how people have two different modes of thinking. System 1 is fast, intuitive, emotional and suppresses ambiguity. System 2 is slower and more logical, but requires far more conscious effort.
Research from behavioral economists and psychologists such as Thaler and Kahneman identifies self-destructive tendencies standing in the way of investment success. Developing an awareness of behavioral tendencies can help investors to have the insight necessary to avoid common behavioral traps.
Behavioral biases. Confirmation bias is the tendency to seek evidence that supports preexisting beliefs, and to interpret information in a way that supports an existing position. Confirmation bias is a major factor in today’s political environment, with news sources and information feeds increasingly slanted to the pre-existing beliefs of a subset of the population. Investors often fall prey to confirmation bias, avoiding or discounting arguments and statistics that contradict the point of view favoured by the investor.
The availability bias or heuristic is a mental shortcut that occurs when people make judgments about the likelihood of an event based on how easy it is to think of examples. Some events are easier to recall than others, not because they are more common but because they stand out in our minds. Events that draw more media attention, such as plane crashes, earthquakes and terrorist events, are considered to be higher probability events than statistics would indicate.
People ascribe a higher probability to information and events that are more recent, that were observed personally, and were more memorable. Memorable events tend to be magnified in importance and are likely to cause an emotional reaction. Investors commonly use mental shortcuts or rules of thumb for guidance, relying too often on stories rather than analysis in order to make decisions. Headlines satisfy the human need for coherence and require less effort than applying statistical reasoning.
Overconfidence is another common behavioral challenge. Kahneman’s research cited a study of entrepreneurs in which 81percent of respondents put their personal odds of success at 70 percent or higher, in stark contrast to statistics that indicate that the odds of a small business surviving in the U.S. for five years are about 35 percent. The Illusion of control is a related bias, in which individuals overestimate their ability to influence external events. Start-ups are influenced as much by the actions of competitors and changes in the market as on their own efforts. Overconfidence and the illusion of control can lead to a tendency for investors to trade too much, or to underestimate the role of luck or timing in investment success.
Loss aversion is the tendency of humans to feel more pain from economic losses than pleasure from an equivalent amount of gains. Loss aversion contributes to the tendency of investors to sell winners too soon and hold on to losers for too long. It is also a factor is behavior in which people become risk-averse in seeking gains while seeking risk in order to avoid losses.
Strategies for counteracting behavioral biases. Awareness of behavioral biases can provide a roadmap for counteracting harmful behavior. Although mental shortcuts are helpful in daily life, a slower and more methodical approach is more likely to be a recipe for investment success. Overcoming confirmation bias is conceptually simple, but hard in practice. Seeking contrary opinions is one important strategy, and media timeouts to reduce stimulus is another.
Many investors ignore prior probabilities (base rates) in thinking about an investment or a portfolio of investments. Statistics and other reference information provide context into how frequently an event has happened in the past, the magnitude, and the duration. Base rates can also identify the potential size of an opportunity. A slower and more systematic approach can counter availability bias while countering the temptation to be overconfident.
Some firms complete premortems before making an investment. Participants are asked to imagine being one year in the future and provide an explanation of why the investment failed. The concept of a premortem helps to overcome “group think” and often identifies threats that have been neglected in the investment analysis. Whether making decisions as a group or individually, the premortem can raise the quality of investment decision-making.
A common investment misconception equates risk to volatility, reinforcing the behavioral bias of loss aversion. Volatility should not be what matters for most investors. Rather than volatility, the most significant risk is that of a permanent loss of capital.
Most causes of permanent loss of capital are self-inflicted. Failing to maintain enough liquidity to meet unexpected expenses increases the likelihood of having to sell assets at inopportune times. Being overly leveraged also raises the vulnerability of being a forced seller, the unfortunate fate of too many real estate investors in 2008 and 2009. Panic is another common trigger of permanent loss of capital and provides another argument in favor of maintaining a moderate intake of financial news.
The most successful investors are likely to heed the lessons from the traditional world of academic finance, as well as the behavioral world of Thaler and Kahneman. Investors who have well-diversified and liquid portfolios constructed with methodical System 2 thinking are more likely to avoid the traps that come from behavioral biases.
The original article appeared on money.usnews.com and is written by Dan Kern. It is available here.