For years, Homo Economicus was the model that economists used to understand our choices about work, leisure, and investing. Homo Economicus is rational and egocentric, always calculating the profits and losses of every possibility before making the optimal decision. Homo Economicus is also a figment of our imaginations. Over the past several decades, the revolutionary science of behavioral economics has shown us the many ways in which our biases result in suboptimal decision making. By recognizing these biases, we can protect ourselves from the errors that can separate us from our money, but in order to do that, we must first understand what they are and how they affect us.
We are terrible at predicting the future. We’re not as bad as the average economist, of course, but that is rather faint praise. In the cacophony of noise that spews forth from the media on a daily basis, we often lose sight of the forest for the trees. We mistake every comment by Ben Bernanke or every uptick in initial jobless claims as important news that will drive the markets for weeks and months on end. We are prisoners of the moment, which is why we tend to buy and sell at the worst possible times. We dump stocks at the bottom of a downturn when everyone is depressed and buy them at the top of the market only after we missed most of the gains. This is a recipe for disaster in a market where today’s darling often becomes tomorrow’s dog. When we forget this fact, we risk following the herd to slaughter.
We all like to think of ourselves as unique little snowflakes who have our own interesting take on the world. However, when it comes to our investing behaviors, we often act less like lone wolves and more like lemmings happily jumping off a cliff. Ever since some Dutchman handed over his life savings for a tulip bulb, we’ve frequently lost track of our senses and succumbed to the euphoria of the moment. Today, we buy up our own version of tulip bulbs in the guise of Internet stocks and mortgage-backed securities. The more the world changes, the more it seems to say the same.
Everyone loves making money, especially during the excitement of an extended bull market, but research by behavioral economists has determined that we hate losing money even more. This is entirely understandable. However, in our attempts to avoid the pain of losing our hard-earned money, we can paradoxically engage in the very behaviors that cause us to lose money. We lose sight of our long-term plans by locking in profits from winning funds while stubbornly holding on to our bad funds because somehow those losses aren’t “real” until we actually sell them. It’s important to separate the process from the result in our investment activities: Keep the quality funds and jettison the poor ones, regardless of their recent performance.
Even if we recognize many of these biases in others, we often fail to recognize them in ourselves. Sure, there are lots of bad drivers out there, but we’re clearly the exception. Right? Well, 90% of drivers would agree with that statement! The same belief in our “above-average” capabilities applies to our investing abilities. It’s certainly difficult for most people to beat the market, we reason, but somehow we can take advantage of inefficiencies in small-cap stocks or foreign markets to make a handsome profit for ourselves. To others, that chart is just a random pattern of lines, but to us, it is a classic cup-and-handle pattern that is ready to break out. Unfortunately, overconfidence can quickly lead to delusion, so it’s a good idea to seek input from pros who can evaluate your abilities more dispassionately. You should also use data to evaluate your results and measure your abilities; just make sure you don’t cherry pick your results!
In an ideal world, we would objectively weigh all the pros and cons of a given course of action and proceed accordingly. In the real world, this isn’t close to how we actually make decisions. Instead, in a world awash in data, we tend to selectively pick facts that confirm our previous beliefs or ignore things that might go against our long-held assumptions. By avoiding uncomfortable news, we might temporarily feel better about ourselves, but it could be extremely dangerous to our finances. If you want to succeed as an investor, you have to check your ego at the door and be willing to change your opinions as new facts come to light.
Traditional economics has shown us how simple successful investing can be: focus on the long-term, minimize your costs, and don’t attempt to outsmart the market. However, behavioral economics have shown us how difficult it can be to follow these simple strategies. When Warren Buffett said, “investing is simple, but not easy,” he was recognizing a difficulty that most people have in reconciling the truths of investing with their inability to act on them. Once you appreciate this fact, you will be well on your way to overcoming your own biases and becoming a successful long-term investor.
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