I hope this article doesn’t disappoint you if you were hoping for a Bucks Fizz tribute blog – I was never a fan unfortunately – although they did come up with an innovative use for Velcro. And my favourite champagne cocktail is actually a Bellini (peach juice, or Archers if you prefer, with champagne – yum!).
This is the latest post of a series that have ‘gently’ introduced the importance of understanding what influences our decision making before we start investing. And what becomes clear is that emotions can be bad, they lead us to make the wrong financial decisions at the wrong time.
We have all sorts of behavioural biases that fuel those emotions. I mentioned in my last blog an example of ‘confirmation bias’ – I like red wine, think it is healthy for me and will give more relevance to any information that suggests the same.
But there are plenty more. I detail the few that are most relevant to investing below but Wikipedia lists almost 100 other examples that affect the way we think. You might be surprised how many you recognise in yourself and others. My favourite has to be the ‘IKEA effect’, but then I am sitting at an Ikea desk in an office with an Ikea book case.
Unfortunately, some of us also experience ‘overconfidence’ bias before completing our Scandinavian beech veneer furniture because we should have looked more closely at the instructions. And ‘planning fallacy’ means it took longer than we expected and it would have taken even longer if someone else hadn’t pointed out an obvious mistake – to which we respond with ‘I knew that’ or ‘hindsight’ bias.
Why do we have them? From an evolutionary perspective, having our minds already wired in a certain way may be more useful in certain situations. For example, the speed at which we make a decision is sometimes more important than its accuracy. And social skills needed to keep the population ticking over don’t necessarily lend themselves to being rational.
Given the basic instinct for survival and the need to procreate, most men know the answer to their partner’s question, ‘does this make my bum look big?’ is not the rational answer, ‘no, it’s all the food you eat’.
When you become aware of these biases, you’ll see them everywhere – especially in the media and when you’re shopping. And the government cabinet office announced only last week that it is to spin off into a private group its’ ‘Nudge’ team.
Otherwise known as the Behavioural Insights unit, it uses psychology to try and change public behaviour, from the adoption of donor cards to pension contributions. The team is called ‘Nudge’ as the unit was influenced by the authors of the book of the same name. It’s an enlightening read, if a bit longwinded, but it’s hard to entertain when you’re dealing with statistics.
So how do we invest in a world where 80% of drivers think they are better than average? – a statistic often quoted by Daniel Kahneman , one of the fathers of behavioural economics. How do we adjust for biases that can make us overly pessimistic or conversely wanting to ‘get rich quick’?.
The answer is to have an adaptable plan and I explain in the other areas of the website how we go about doing just that and tailor it to an individual client’s needs. But in brief, some strategies aim to remove the influence of bias as much as possible using a passive investing style. Others specifically try and take advantage of swings in sentiment, such as ‘value’ or ‘momentum’ techniques. I will explain those in greater detail in another post.
Benjamin Graham, the father of ‘value’ investing summed up his philosophy in a simple quote, ‘we seek to buy from pessimists and sell to optimists’. And my next blog will be about his most successful and famous disciple, Warren Buffett.
Finally, I’d like you to remember that the discussion above is not about intelligence. One study suggested that most professors believe they are better than average. And more relevant to today, banks using risk models based solely on probability calculus would have been better to allow for the experience of the inventor of calculus – Sir Isaac Newton.
He made and subsequently lost a fortune in what became known as the South Sea bubble and is quoted as saying, “I can calculate the motion of heavenly bodies, but not the madness of people”.
But then, maybe I’m guilty of hindsight bias…..As ever, if you have any questions, please feel to contact me.
There have been studies on the effects of cognitive biases on making choices from the most mundane to those of governments to go to war. Below I have detailed some of those that relate to investing.
Strictly speaking this refers to trials that show that when respondents are 100% confident in an answer they are right 80% of the time. But in investing terms, in addition to overestimating their own knowledge, people underestimate risk and believe they have more control over events than can be expected
Similar to ‘group think,’ this explains that we have a herd mentality and love to go along with the crowd – even when on our own we would rationally take a different view. You can read about an experiment demonstrating this here: Asch Conformity Experiments.
This is included in the piece, but I must witness nearly every day examples of this. We have a tendency to put greater significance on news and information that reinforces an existing view and ignore those that don’t.
This perhaps explains the biggest difference in performance between novice traders and those with experience. We seem to attach more emotion to a £100 loss than to the same amount of profit. Consequently we are more likely to keep a loss making position hoping that it will recover and sell a profitable position too quickly.
The results of six throws of a coin are HHHHHH. Is the next throw of the coin more likely to be heads or tails? The answer, as any economist will tell you, is that the chance of either is the same at one half. The gamblers fallacy is the belief that after a run of six heads a tail must be more likely. However, as your investment adviser my first decision would be to check the coin!
Others to look up:
Post purchase rationalisation
Observational selection bias
Status quo bias