Image source: Pixabay
Image source: Pixabay
No matter how you spin it, economics and finance are inherently governed by human patterns of behavior. Finance, the markets and the economy are all made up of transactions between people, and almost every single piece of the whole is governed by emotions. If economics are not behavioral, I don’t know what the hell is. If you agree with biases being existent in your own decision-making, your natural reaction should be to find tools to protect yourself.
The really old school stream of efficient-market economists rejects the notion of exploitable psychological biases in markets, partly because irrational markets don’t lend themselves to the application of mathematical models. Modern behavioral finance, led by Kahneman, Tversky, and Thaler, has accepted and studied biases in economic decision-making more closely. There are many other useful sources, but the one speech that fills the most holes in my mental latticework is Charlie Munger’s famous speech “The Psychology of Human Misjudgement”,
The subject of this article is detailing tricks you can employ to protect yourself from mental biases. If you are yet unfamiliar with biases or are in need of a comprehensive overview of biases, I strongly recommend at least listening to Charlie’s speech and reading his commentary on the speech, available in “Poor Charlie’s Almanack”.
Biases Matter in Investing More Than Any Other Profession
There are several factors that contribute to investment professionals having a propensity to falling victim to mental shortcuts. For simplicity, we differentiate between the reptilian and the rational brain, a differentiation that can be backed up by research about the physical attributes of the brain.
Responses by our reptilian brain are instinct and reaction based, as opposed to rational, well-considered thought. The reptilian brain responses, mental shortcuts, biases, heuristics, or whatever you want to call them, developed as a natural part of evolution because they apparently had value to our ancestors. While it was useful for a caveman to stoop when everybody around was stooping (to avoid getting eaten by some flying monster), it is not necessarily useful for an investor to always simply “go with the herd”. Few jobs today require instinct based behavior, and while most jobs require rational thinking, investment professionals are especially prone to do exactly the opposite – resort to reptilian brain responses. Here are the main factors for why investment professionals are more prone to behavioral biases than other professions, and why the problem is getting worse as information flow progresses.
- The degree to which randomness dictates the outcome is great. While it would be fairly easy to evaluate how a dentist will perform in future operations based on past performance (or most professionals that work with their hands), it is hard to assess the true ability of an investor just from past performance, and hard to forecast performance. It could be the result of an inability/unwillingness to accept the degree of randomness involved in the outcomes that makes investors prone to mental shortcuts.
- The problem is ill structured, complex, information incomplete and ambiguous. This set up makes it likelier for people to use their reptilian brain, instead of rational thinking (see “The Little Book of Behavioral Investing” Preface).
- The feedback is not linear. As I said, there is a great deal of randomness when it comes to investment performance. While you will be likely to attribute good performance to skill, and bad performance to circumstances, the truth is that the risk and real probabilities are not apparent before nor after the fact. Suppose I bought puts because I believed there was a 90% of an upcoming earnings reports of company XYZ falling short of expectations. Even if the report is a positive surprise and I lose money, I can’t assess whether the bet was good or bad – I can’t see the odds of reality before or after the fact. Reality happens only once and you can’t rerun history. Also, investment situations always differ in circumstances, which makes analysis based on historic data somewhat more difficult.
- The drivers of outcomes are barely verifiable. Similar to the previous problem, you don’t know beforehand nor after the fact what factors are actually driving the situation. You might have figured that your investment thesis did not work out because the CEO failed to perform, while in reality other factors that you did not even consider wound up driving the value of your investment.
- Investment management is a pure thought job, but most of us work in environments where there is a pressure to perform a certain workload, with certain results, in a certain amount of time. Under growing time and performance pressure, it is easy to resort to mental shortcuts. This may even be a necessary reaction from the brain.
- Not only has the reaction window shrunk significantly over the last few years, information flow grew tremendously with the emergence of the internet at the same time. The challenge for an investor has shifted somewhat over the last 30 years from actually acquiring information to filtering the useful from the noise. The increased information flow makes for more noise (useless/meaningless information), sometimes overstraining the mental capacities of the individual and making it more compelling to resort to mental short cuts. At the same time, the greater available information makes it easier to fool yourself into believing that you have a greater degree of visibility than you actually have. Even though you have thousands of pieces of information at your fingertips, some of the most important ones may wind up not even being considered due to the sheer volume of information available.
- Maybe it is rational, or even necessary, to behave irrationally at times. Sometimes the environment pressures you to do something irrational. Could you argue that a portfolio manager should sell a position that he likes (assume for example a 5% gain foregone) because his biggest LP is terribly worried about the position and it is straining their relationship? In markets, you are dependent on the views of other market participants to realize the value of your investment. If you buy a stock that is worth $1.00 for $0.50, you have to find someone to give you $1.00 before you can realize a gain. If you accept that market participants are biased, you also have to accept that what they will pay you for your shares will be biased. Additionally, there is a feedback loop between objective reality and the way participants view reality (see George Soros Reflexivity). For example, market participants that bid up a stock price allow the company in question to realize real value from the rise in share price through acquisition of other companies by means of shares. Often times, it seems like market participants are confusing the price for a signal. These additions make the investment business inherently more complex, because the rational thing in the long run might be doing something that seems irrational in the short run (there are interesting links to evolution theory which I can’t comment on further at this point).
If you are an investor, you have to accept that your genetic makeup makes you unfit for your very profession, and you have to find ways to