The Many Errors Investors Make, and a Few Fixes

Behavioral Finance expert Meir Statman teaches finance at Santa Clara University, and he seems to have packed several courses worth of work into his new book, What Investors Really Want. With a droll sense of humor and a skill for drawing parallels between financial behavior and how we act in the rest of our lives, Statman manages to make his brand of finance a surprisingly fun read.

Chapter 2 (entitled “We Have Thoughts, Some Erroneous”) sheds light on four types of errors we make when investing:

  • Framing Errors
  • Representative Errors
  • Availability Errors
  • Confirmation Errors

Framing Errors
It’s easy to make a mistake when you’ve framed the issue incorrectly, and many investors make that exact mistake with their money. We think we can, through practice and diligence, learn to beat the market. Investors imagine investing is like hitting a tennis ball off a practice wall: given enough time, we’ll get pretty good at it. The ease with which investors can match the market’s performance (through indexing) contributes to this perception. If it’s easy to match the market, with some work, we should be able to beat it, right? That’s the wrong frame, however. The better “frame” for thinking about investing  is not a single person hitting against an unmoving wall, but  “playing tennis against a possibly better player.” Incorrect framing is part of why we fall for stock touts predicting “Amazon will go through the ROOF!”, etc.
Solution: Create a sort of cognitive “app” which poses the question: “Who is the idiot on the other side of the trade? Am I perhaps the idiot?”

Representativeness Errors
When a telemarketer calls you probably usually say a quick “No thank you.” But if you ever do hang on it may be because of “representativeness” which is the awkward word for our tendency to associate experiences with prior experiences. Does that caller sound like another solicitor I once heard from who turned out to be worth listening to?
Solution: To focus instead on “base rate” information. In this example, the much larger percentage of telephone marketers who were not worth listening to. A mutual fund manger may have six winning years in a row, but even though that seems quite remarkable, it’s still quite possibly largely a run of very good luck. The base rate information on funds, Statman writes, is that most funds fail to outperform over time. Patterns can be deceiving. Just because someone won a $10.7 million lottery playing famous athletes uniform numbers does not mean that’s a consistently winning strategy.

Availability Errors
Near misses and small wins make a big win seem “available”. Casinos, online trading platforms and mutual fund companies all promote their winners, making the odds of your winning with them seem higher.
Solution: Look at the entire picture.

Confirmation Errors
The errors we make when we look for proof confirming our hypothesis/intuition/belief and overlook evidence that doesn’t conform to our idea.
Solution: A structure that forces us to consider all the information.

It’s hard to read this chapter and not recognize some of ourselves in Statman’s descriptions. But don’t just take my word for it. Praise for the book has already rained in from Vanguard founder Jack Bogle, A Random Walk Down Wall Street author Burton Malkiel, Nobel Prize winner Harry Markowitz, writer Bill Bernstein, and many others.

Statman will be sharing more of his insights with Portfolioist in early December when he’ll step in as a guest blogger for a day.

Please send in questions for Professor Statman or issues you’d like to see him address. Add them to the comment box of this post, or email byrnesn@folioinvesting.com.

One thought on “The Many Errors Investors Make, and a Few Fixes

  1. Paul K

    Thanks for the article on Meir Statman. Professor Statman’s work in the field on behavioral finance is very interesting, and I look forward to reading his new book. A day with Portfolioist will also be something not to miss.

    Paul

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