Not long ago, I found myself engaged in the delicate task of trying to lead my son to a sensible decision without giving the impression I was telling him what to do. He was considering not taking traffic school for a speeding ticket. It’s rare to get the opportunity for a “do-over.” He could pay more for insurance in the long run if he passed up the chance today to make amends for the ticket. The consequences of a poor decision can last many years. I enlisted the old adage about “shooting oneself in the foot.”
Recently The Wall Street Journal ran an article entitled, “Training the Brain to Choose More Wisely.” It opened with the sentence, “The human brain is wired with biases that keep people from acting in their best interest.” In the last forty years a field of inquiry has emerged called behavioral finance that has shed new light on how we make investment choices.
Young people aren’t the only ones who fall prey to unwise choices. We adults tend to think of ourselves as sound decision makers; we make hundreds of decisions each day. Yet we are busy people in a complex world. We cannot possibly give in-depth consideration to every choice.
Many Examples of Poor Decisions
The current financial mess affords no shortage of examples of poor decision-making. Didn’t we learn anything from our mistakes in the dot-com era? Shouldn’t we be getting better at making decisions about our investments? We consider ourselves rational thinkers but according to researchers in the field of behavioral finance, we often demonstrate irrational and predictable biases that can result in poor decisions. This article will examine some of the common biases that can adversely affect our investment decisions.
Many people believed real estate values would keep going up as they had for many years; they were convinced that real estate was still a good investment. This belief, based on a prior set of conditions which turned out not to be sustainable, constituted a biased assessment of risk. Many investors wanted to buy more property because it appeared that everyone else was making money at it. They were motivated in part by a bias to follow the herd. Now that the tide has turned on stocks and real estate, investors may have a hard time selling investments that have declined in value, even though lower prices may also present better opportunities for buying. Investors in this case may have loss aversion. In each of these situations, the tendency to act on unexamined assumptions leads us away from making good decisions.
A biased assessment of risk occurs when the brain takes a shortcut in evaluating a risky situation. The example of a risk that comes readily to mind, such as unsafe teenage driving, seems to present a greater threat than something which may actually be more likely to cause harm, such as suffering a stroke. Yet because of a bias in assessing these two risks, I might overestimate the risk involved in loaning my son the car for the evening. Yet the truth is I am more likely to have a stroke than to be hit by a teenage driver.
If it is easy to recall an example of something, we give it greater weight in our thinking. This tendency contributes to the bias of underestimating risk as well. Buying property two or three years ago represents acting on the bias of underestimating risk. We could readily think of so many instances in which people did well with real estate. There were so many examples of price appreciation; we concluded homes were a good investment, when in fact that was no longer true. Our bias influenced us to judge the true probability of an event incorrectly (price declines.)
When it comes to investment decisions, others often influence us, even when following in their footsteps is not necessarily rational or in our best interest. Upon seeing others do something, we tend to ask whether the same might be good for us. We hear that our neighbor got out of the market last November and think maybe we should do the same. Most investment ideas are profitable for a limited period of time. Recognizing trends early is essential. Predicting the trend is even better.
We Like to Follow the Success of Others, but…
People do like to go along with the crowd. Yale professor Robert Shiller talks about social contagion. Most people come to think the optimistic view is correct just because everyone else seems to accept it as true. Given this inherent behavior, it is easier to see how following the herd might lead us to suspend critical thinking in evaluating complex investment decisions.
It should come as no great surprise that people hate losses. Loss aversion, however, can elicit unproductive and irrational behavior. People have an extremely hard time selling a stock or fund that has sustained a loss. Recognizing a loss is equivalent to acknowledging having made a mistake. This leads to the crafting of excuses. We cling to the fond hope that the investment will return to its previous value. If it could just get back to where it was when we bought it, then we would sell. We hope the market will validate the original purchase. This seldom plays out and instead creates inertia, a strong desire to keep our current holdings – i.e., to do nothing. We forego making trades or choices of greater benefit to us. People tend to make poor decisions here because they fear losing or giving up something, even though change is very much in their best interest.
The brain uses shortcuts that can lead to erroneous perceptions or conclusions about risk. This doesn’t mean we are bad at making decisions. It just points to the need for better understanding of tendencies we bring to the decision making process. As in so many aspects of investment strategy, knowledge is power. Knowing oneself is a vital aspect of successful investing. Investing entails risk. Knowing our own temperament for risk – our tolerance for risk and our biases in approaching it – are wonderful tools to ensure that we take only the risks that are right for us. If we can understand our risks in investing, we lessen the chance we will end up shooting ourselves in the foot.