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If you’re an introspective person who has spent any significant amount of time investing or trading, or observed someone else who has, you’ve come to realize that one of the most fascinating things about it is the psychology and emotional responses people have regarding their investments. You’ve surely seen people who became totally attached to an investment that only seems to be going downhill, maybe you’ve made a stupid decision based on something you overheard at the gym, or perhaps you’ve been annoyed by a friend who told you that he “knew for sure that telecoms were going to crash”, but for some reason didn’t warn you in advance. (in case you’re wondering, these specific things have not happened to me, but similar things have)

As it turns out, there are several well-researched cognitive biases that can explain much of this behavior. You’ve probably heard the word “bias” used by various political factions to describe anything they disagree with, but in experimental psychology it refers to a general tendency for people to believe or act irrationally in a specific and predictable manner. These are generalizations, of course it’s not true that everyone exhibits all these biases all the time, but I found, as I learned about them, just how often everyone I know (including me) lets them show.

One of the more well known biases is confirmation bias, and its close relative, congruence bias. These represent the tendency for people to seek out information that supports something they already believe. There is a classic experiment that demonstrates this tendency - four cards, each with a letter on one side and a number on the other, are dealt:

E 7 F 4

People are then asked to turn over two cards to test the rule “Every card which has a vowel on one side has an even number on the other”. People will almost always turn over “E” and “4″, even though the only way to test the rule is to turn over “E” and “7″. They are specifically looking for evidence to support the rule, rather than testing if it can be contradicted. This type ofbehavior is so pervasive that we barely notice when we’re doing it. Rationally, however, to develop more confidence in a hypothesis, we should seek to disprove it.

In my experience, almost everyone exhibits confirmation bias in making investment decisions. Those who are excited about the prospects of housing are much more likely to read the positive outlook from the NAR website than they are to seek out the housing bubble blogs. If they accidentally come across evidence that contradicts their beliefs, the will hold it to a much higher standard of proof, and then seek out a rationalization from one of the sources they already agree with. Recent research has demonstrated that the reward centers of the brain become active when people are able to rationalize away facts that they dislike. I’m sure some of you have gotten a hot tip from a friend and done some “research”, which involved seeking out similar opinions from some experts while rationalizing why the other experts were wrong.

Next up, we have the bandwagon effect. This is huge in investment psychology. It refers to the tendency of people to value things simply because other people do, even in the presence of contradictory evidence. The implications for this in investing are obvious. History is full of examples of speculative bubbles - The South Sea Company, Dutch Tulip Mania, Florida Real Estate in the 1920s, Beanie Babies and dot-coms. Business Week famously ran a cover story called “The Death of Equities” in 1979, not long before the longest bull-market in equities ever. Although data on confidence in an asset as a predictor of performance is hard to come by, it does appear that there is higher risk associated with investing in an area that everyone is already excited about. It is also clear that many “legendary investors” made their money by choosing investments that were very unpopular at the time. Despite this, most people will look to the consensus. There are probably two reasons for this. The more obvious one is that they don’t trust their ownjudgment , which leads them to look to others for guidance. Possibly a more powerful reason is that failure in a group is much less painful than failure by oneself. If you’ve ever bet on the “Don’t Pass” line at craps, you’re aware that even success on your own isn’t always that great. Some psychologists have characterized regret avoidance as a bias which, given that possible regret could be much greater going against the crowd, might help explain the bandwagon effect.

The “hold” recommendation that some analysts put on stocks has always confused me. The implication that if I have a stock I should hold onto it, but if I don’t already own it I shouldn’t buy it. Transaction costs now are extremely low, so if something isn’t worth buying, then why is it worth hanging on to? Further, whenever I’ve mentioned this to other people they admit that a “hold” had always seemed perfectly reasonable to them before. It seems to me that this may be due to a combination of the endowment effect, the tendency to value something that you already own more highly and omission bias, which is the belief that negative outcomes caused by inaction are more acceptable than negative outcomes caused by action. In light of these biases, the “hold” recommendation seems perfectly reasonable, since it basically means “sit tight and don’t do anything you might regret”. These biases also seems to effect people’s decisions about selling a stock that they have already lost money on - if we ignore transaction costs, then the decision to sell a stock is equivalent to the decision not to buy the stock, but many people will choose not to “take the loss” on something which they would not ordinarily buy.

We know that we’re more likely to enjoy a song if we’ve heard it a couple of times before, more likely to buy a product for which we’ve seen commercials and more likely to vote for a politician we’ve met, even if her policies don’t match ours any better than the other candidates. This is known as the exposure effect. People prefer things that they are familiar with - this bias is so strong, that it can even be shown that people who are shown symbols for an imperceptible amount of time will later express a preference for those symbols over others. By the same token, people who pick their own stocks will almost always prefer companies they have heard of, even if they don’t use those companies’ products, and there are other choices that better match their investment criteria. This will often lead to a portfolio of large companies or consumer-product companies and an overall lack of diversity.

Finally, we have hindsight bias. Remember your clever friend who “knew that was going to happen”? Or perhaps you’ve kicked yourself for not taking advantage of an opportunity that you just knew would have led to great success? You or your friend may be suffering from hindsight bias, which is the tendency to overestimate the inevitability of past events. Many experiments have demonstrated that when people are asked to predict the probability of an event before it happens, and asked again after the event what their prediction was, they often overestimate the probability they assigned to the eventual outcome. Your friend isn’t lying or showing off (well, kind of) when he says that he knew it was going to happen, he actually believes it.

Perhaps by learning about our own biases, we can understand more about why we make mistakes in investment decisions and other areas of life, and try to correct for them. However, given that there is another bias, blind spot bias, which is a tendency not to correct for your own cognitive biases even when you’re aware of them, this might be unlikely.

(n.b. I am not an expert in psychology, and I apologize if I have used any terms incorrectly)

July 14th, 2006 | Category: Uncategorized | Subscribe to comments | Leave a comment | Trackback URL