Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.
Barry Ritholz (of The Big Picture and a Sunday Business columnist at The Washington Post) recently contributed Investors’ 10 most common mistakes to The Washington Post Business Section quarterly investing section. It’s a commentary that he has been working on for a while — the ten topics are listed with links to longer discussions of each common mistake here. I created my own investing “checklist” (here) in response to Barry’s original list. For yet one more iteration of the theme, I offer my list of Investors’ 10 Most Common Behavioral Biases. There are a number of others, of course, and more will continue to be uncovered. But I think that these are the key ones.
1. Confirmation Bias
We like to think that we carefully gather and evaluate facts and data before coming to a conclusion. But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first. Only thereafter do we gather facts and see those facts in such a way as to support our pre-conceived conclusions. When a conclusion fits with our desired narrative, so much the better, because narratives are crucial to how we make sense of reality.
2. Optimism Bias
This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. Indeed, we live in an overconfident, Lake Wobegon world (“where all the women are strong, all the men are good-looking, and all the children are above average”). We are only correct about 80% of the time when we are “99% sure.” Fully 94% of college professors believe they have above-average teaching skills (anyone who has gone to college will no doubt disagree with that). Since 80% of drivers say that their driving skills are above average, I guess none of them drive on the freeway when I do. While 70% of high school students claim to have above-average leadership skills, only 2% say they are below average, no doubt taught by above average math teachers. In a truly terrifying survey result, 92% students said they were of good character and 79% said that their character was better than most people even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam. Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are either to succeed or fail. In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.
3. Loss Aversion
We are highly loss averse. Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains. Thus the dis-utility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives. Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, biases 2 and 3 – unjustified optimism and unreasonable risk aversion – conflict. As a consequence, we tend to make bold forecasts but timid choices.
4. Self-Serving Bias
Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week of practice, worked hard and executed on Sunday”) while the bad stuff is always someone else’s fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).
5. The Planning Fallacy
In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias and self-serving bias. Most of us overrate our own capacities and exaggerate our abilities to shape the future. The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof. It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect. It’s why the results we achieve aren’t as good as we expect.
6. Choice Paralysis
Intuitively, the more choices we have the better. However, the sad truth is that too many choices can lead to decision paralysis due to information overload. For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases. We are readily paralyzed by too many choices.
We all run in herds — large or small, bullish or bearish. Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree. Even hedge funds seem to buy and sell the same stocks, at the same time, and track each other’s investment strategies. That affinity fraud (e.g., Bernie Madoff fleeced the Jewish community to which he belonged) is so common it is definitive evidence of herding.
8. We Prefer Stories to Analysis
As noted above, narratives are crucial to how we make sense of reality. They help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts we take them to represent. Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding. Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances. A corollary to this problem and to confirmation bias is what Nassim Taleb calls the “narrative fallacy” — looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen.
9. Recency Bias
We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash. The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the financial crisis. That’s recency bias.
10. The Bias Blind-Spot
I have written many times about the cognitive biases which plague us and make it difficult for us to make good choices, including (obviously) here. Knowing about them is imperative if we are going to deal with them. We would always be wise to factor in these biases when performing analysis and making decisions. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people. Here is a wonderful (both hysterically funny and achingly sad) example.
About Robert Seawright and the Above the Market Blog:
Above the Market is the blog of Robert P. Seawright, the Chief Investment & Information Officer for Madison Avenue Securities, a broker-dealer and investment advisory firm headquartered in San Diego, California. Its focus is the capital markets, economics and personal finance from a data-driven perspective. His About Me profile is available here.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Madison Avenue Securities is not affiliated with FOLIOfn or The Portfolioist.
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