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Why We Think We're Better Investors Than We Are

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By  Stephanie Oakley
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From their earliest days, research efforts now known as behavioral economics spawned a large quantity of studies centered on investment. Not because they were interested in stocks, rather the hive of activity in investment markets provides a robust data sets for analysing “judgment under uncertainty”. Every day, global markets provide researchers with billions of data points for understanding how people make choices when resources are at stake and the outcome is unknown.

Indeed, the majority of cognitive biases and shortcuts that influence everyday judgment and choice have analogues in investment behavior.  Consider the “sunk cost fallacy,” a primary reason an unsuccessful investor might balk at selling money-losing shares. Many investors obsess over their sunk cost — the original investment amount — in a non-conscious desire to justify their earlier decisions. Many also fall prey to “loss aversion,” which tells us that humans typically respond to the loss of resources (be it time, effort, emotion, material goods or money) more strongly than they react to a similar gain.

What differentiates a professional investor from the average investor is their justification for engaging in their activity. Money managers are trained to do what they do, while the majority of investors are not. Ask a random player in a law firm’s basketball league whether he or she could compete with LeBron James, and the most common response will be laughter. Yet many people willingly compete with the billionaire investor Warren E. Buffett. Money managers, at least, are paid to make investment decisions. But why do non professionals believe they can outperform the professionals, or even identify those pros who will outperform? Many biases and cognitive errors contribute to this costly behavior, a few deserve mention.

Overconfidence

A pair of University of Pennsylvania psychologists collected more than 25,000 forecasts from people whose job it was to anticipate how the future would unfold. All demonstrated remarkable overconfidence. When they were 80 percent sure of their predictions, they were correct less than 60 percent of the time. In a 2012 study by the State Street Center for Applied Research, investors were asked about their financial acumen. Nearly two-thirds rated their financial sophistication as advanced. However, when they ran a financial literacy exam the average score was just 61 percent, barely a passing grade. This disconnect between actual and perceived sophistication is evidence of how widespread the overconfidence bias is.

Optimism Bias

Overconfidence is hard-wired into our brains because it is useful. Many of our mental biases evolved because they make us cautious or they otherwise protect us from harm, but overconfidence is part of a suite of cognitive traits that serve to propel us forward. Just as no one would think to write a children’s book about a train engine that repeats, “I think I can’t”, there would be few explorers who would venture into the wild and few entrepreneurs would start new businesses — unless they believed that they would succeed in the face of long odds.

A bias toward optimism helps to explain why many, if not most, smokers are confident that they will not develop cancer; why many drivers are certain that their texting will not lead to an accident; and why many investors believe they can outperform the market. We are evolutionarily programmed to believe that things will work out.

Hindsight Bias

More confounding than the existence of investor overconfidence is its persistence: As markets teach us costly lessons, we should grow humble. But the fact that many do not reflects what Professor Hirshleifer describes as self-enhancing psychological processes. One of the biggest esteem builders is hindsight bias, or the tendency to rewrite our own history to make ourselves look good. In landmark experiments by the psychologist Baruch Fischhoff, then at Hebrew University, study participants were directed to make predictions about real-life events, then were asked periodically to recall the events and their predictions after the fact. His findings? Participants consistently misremembered their forecasts, in ways that made them look smarter. Too often we look back not in anger but in awe, at least of our own capacities.

Attribution Bias

Of course, many people easily recall failures, which suggests that hindsight bias is not all that powerful. But even when our failures remain vivid memories, we remember them in a way that neutralizes their ability to inhibit our present-day decisions. When events unfold that confirm our thoughts or deeds, we attribute that happy outcome to our skills, knowledge or intuition. But when life proves our actions or beliefs to have been wrong, we blame outside causes over which we had no control — and thus maintain our faith in ourselves.

Confirmation Bias

Finally, even if investors are not rewriting history or blaming outside forces, they are still highly likely to miss signs of their lack of skill. The culprit is confirmation bias, which leads us to give too much weight to information that supports existing beliefs and discount that which does not. And those existing beliefs need not be long held. Once a person entertains the idea that ‘this seems like a good investment,’ the processing of relevant information narrows considerably — and in a direction that leads to overconfidence. More often than not, the aforementioned biases lead us to recall investments that soared that we thought to make but did not — and to forget those that plummeted.

The best and simplest method of overcoming these biases is to employ a strategy of self-distancing. It doesn’t mean that you remove yourself from the decision making, but you should seek input or direction from a professional who is trained in this area and who does not hold your biases.


By Joshua Drake, Partner at Crosbie Wealth Management

Inspired by GARY BELSKY - Gary Belsky is an author of “Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons From the Life-Changing Science of Behavioral Economics.”

 

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