Investment Outlook: Third-Quarter 2019 - Looking Past the Numbers: Behavioral Pitfalls in Investing
For decades Economists have developed theories, hypotheses, and rules about how financial markets should work and how investors should invest. The culmination of this work resulted in the wide acceptance of the efficient-market hypotheses in the mid-1960s. A basic definition of the efficient-market hypothesis is that as soon as information about an investment is made public, the value of that investment changes to reflect the news. In a perfect world or academic setting, this works but unfortunately, we don’t live in a perfect world.
The study of behavioral finance didn’t really begin until the 1980s when Dr. Richard Thaler and others began to apply previously established economic theories to the real world. The result was the realization that the human brain is not ideally programmed to respond rationally when dealing with investments and money. With this realization, the new study of behavioral finance was established.
Now that society has widely accepted people’s irrational behavior when it concerns finances and investing, how can this behavior be minimized or eliminated so that rational wealth creation is not impeded? The first step is to identify the most prevalent bias. Just being aware that these biases exist can help investors overcome common mistakes. Over the course of the next few quarters, we will explore different common behavioral pitfalls and look at ways to overcome or at least mitigate their effects.
One of the most common behavioral biases that can be seen in everyday life, in addition to finance and investing, is known as Confirmation Bias. Confirmation bias occurs when a person subconsciously gives more credence to information that confirms an earlier belief. In the case of investing that may mean spending more time and giving more value to articles that offer a positive outlook on a stock that is currently owned and failing to read articles that take a negative stance.
Beyond investing, confirmation bias can clearly be seen when hearing news about a loved one. Take, for example, a teacher calling home to report a child misbehaved. For most parents, the first reaction would be to downplay the negative report. It takes a conscious effort to overcome the initial feeling and begin to absorb the information as it was presented.
By knowing that our brains, by default, experience confirmation bias, we can begin to correct it by making a cognizant effort to keep an open mind no matter what the information may hold. It also may help to force the exploration of both positive and negative information on a topic. In the case of investing, that means reading both positive and negative research reports and articles and then forcing an open mind as the data is processed.
In the coming quarters, we will explore other behavioral biases. In the meantime, I would highly recommend the book Misbehaving: The Making of Behavioral Economics by Richard H. Thaler. It offers a fascinating and in-depth look at many of the topics that we will briefly cover in the coming Investment Outlooks.