|Forbes.com, Spring, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
Having already discussed 16 behavioral traps and biases that trip up all humans, from the anchoring effect to the gambler’s fallacy, it may be hard to believe there are more (and more).
In fact, the ways we trick and fool ourselves are, unfortunately, infinite. Some of the bad behaviors and habits are more common in the investing arena than others. This is the third article in a series of things that top investors recognize and avoid. Being prepared and recognizing that these last seven biases exist costs very little and could save a fortune.
- Rosy retrospection. This is the tendency to remember our decisions as better than they really were (e.g. Mitchell, Thompson, Peterson & Cronk, 1997). It can become a problem when the time comes to making similar decisions. Our bias towards thinking previous decisions were good ones is partly why we end up making the same financial mistakes again. Any recent and habitual buyer of gold for speculative capital gains has been hurt – at least for now – by their rosy retrospective thinking.
- Restraint bias. Many money mistakes result from lack of self-control. We think we’ll control ourselves – like promising to take some money off the table once our rosy retrospection has been realized – but when faced with the choice, we fail to exert control. Perhaps almost to no one’s surprise, studies show people are much too optimistic in predicting their self-control (e.g. Nordgren et al., 2009).
- Representative bias. This is a phenomenon where the brain makes the assumption that things sharing similar qualities are alike. Simply put, it’s when the brain decides that one characteristic of something applies to all its aspects. This representativeness bias causes investors to buy stocks that may have one or more desirable qualities (e.g. Solt & Statman, 1989) but perhaps don’t hold that standard up in all areas. For example, when they confuse a company that “does good things” socially with a good investment (socially responsible investors, take note). In a similar vein, a solid company (good earnings in its own right) may not be solid investment investment (e.g. if those earnings don’t keep pace or exceed those of their peer group stocks).
- The Planning Fallacy. A corollary to optimism bias, most of us overrate our abilities and exaggerate out abilities to shape the future, in other words to try to “pick” or “time” the markets. By extension, we attribute poor results to bad luck and good results to skill. In investing, it’s why the results we achieve aren’t as good as we expected (e.g. Kahneman and Kahnerman, 2011). It’s not just 2002 Nobel Prize winner Daniel Kahneman who describes this. Nate Silver goes even futher pointing out that even with what one might consider all the “best information” in the world, predictions can fail (e.g. Silver 2012).
- Choice Paralysis. Intuitively, we know the more choices we have the better. However, the sad truth is that too many choices can lead to so-called “analysis paralysis” and information overload. Deciding to buy a mutual fund is an easy decision. However choosing from the more than 7,500 of them is not. This helps explain why participation in 401(k) plans among employees decreases as the number of investable funds offered increases (e.g. Mitchell & Utkus). Unfortunately, choice paralysis will keep an investor on the sidelines, leading to missed opportunities.
- Narrative fallacy. Narratives are crucial to how humans make sense of reality. In addition to helping us explain, understand and interpret our world, they give us a frame of reference to remember concepts. Our love of stories is so powerful that we will impose one on a set of events – looking at the past and creating a pattern or constructing a story that explains what happened along with what caused it to happen. (e.g. Taleb, 2007). Where it goes wrong is when we oversimplify or draw connections and inferences that don’t exist. An example of this within the investment sphere is the idea that economic growth always leads to stock market growth. This is the powerful narrative helping drive widespread interest in emerging markets. While there are intuitive links, over the long term the relationship is unreliable and, frankly unproven.
- Favoring stories over analysis. Our love of story is so ingrained that we inherently prefer narrative to data (e.g. Wainberg, Kida & Smith, 2010) even to our detriment. This is one reason why hoards of investors pile into “story” stocks without doing the hard analysis and objective interpretation of data.
Whether it’s combating inaction, due perhaps to analysis paralysis, or over enthusiasm for an unexamined story stock, getting help from a trusted advisor can help you make the most rational decisions.
I’m reminded of the comment by investor and economist, Benjamin Graham, who was famous for his ability to navigate the hope, fear and greed within the market: “The individual investor should act consistently as an investor and not a speculator.”
The challenge for the investor is that the best investment decision may not pay off in the short term. What an investor (versus a speculator) should do is focus on the price he pays for an asset and the risk premium he achieves and trust that he will be rewarded for his discipline far greater and longer than either the short term speculator or fearful non-participant.
One of the best ways to stay focused on being an investor is to work with an advisor who keeps you focused on your investment goals, urging you to stay the course when you are either fearful or overly eager.