By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: October 17, 2011
You can be your own worst enemy if you do not have the proper perspective on your investment portfolio. Human nature can be contrary to successful investing, and you can become a better investor by understanding psychological factors that cause irrational investment decisions. Traditional economics assumes that all investors act rationally, while behavioral economics combines the study of psychology and economics by documenting and explaining forces behind the irrational investment decisions that plague many investors.
Cognitive Biases vs. Emotional Biases
Behavioral economics studies the biases embedded in the human psyche that cause irrational behavior and investment decisions. At the most basic level, behavioral biases are classified as either cognitive or emotional. Emotional biases can be difficult to remedy because they often stem from instinctive reactions and hunches. Cognitive biases, on the other hand, are often the result of flawed reasoning and can be effectively addressed through better information and awareness.
The human mind has an innate ability to classify experiences and ideas. Psychology and behavioral economics have shown that when the mind encounters a new phenomenon that is not consistent with existing classifications, the new phenomenon is often categorized according to pre-existing classifications. The mind will attempt to approximate which type of pre-existing category best fits the new phenomenon, and will then use the pre-existing category of experience to understand the new phenomenon. In an evolutionary context, this behavior allows the mind to use past experiences to rapidly process new information in order to develop quick response reflexes that aid survival.
Nevertheless, irrational behavior can occur when new phenomena are classified according to pre-existing experiences that do not conform to the situation at hand. With regard to investment decisions, this tendency to apply old categories to new situations can lead people to a fundamentally flawed understanding of new phenomena. Your mind has a tendency to predict outcomes based upon pre-existing categories that are not valid in a new context.
The Gambler’s Fallacy
Have you ever seen someone at a roulette table continue to bet on red because previous outcomes have resulted in more red than black? If you have then you may have witnessed the “Gambler’s Fallacy” in action, which is based on the widely held belief that luck runs in streaks. This belief, however, is not rooted in the laws of mathematics but in psychology. Streaks do not exist or make sense from a purely logical, statistical standpoint. Just because you have seen someone toss a coin and obtain heads five times in a row does not make it any more or less likely that the next toss will be heads, because the coin has no memory and each new toss is a purely random event.
Representativeness Bias: Base-Rate & Sample-Size Neglect
Representative bias often manifests itself in what is known as base-rate neglect. When was the last time that you saw someone get very excited about an initial public offering (IPO) without conducting any due diligence? Such excitement typically stems from the misconception that IPOs are lucrative opportunities. This misconception is fueled by “success filtered” stories about people getting rich by investing in IPOs. The reality, however, is that — just like fishing stories — unsuccessful IPOs are not very interesting and their stories are seldom told. The result is that successful IPOs are drastically over-represented in the media and in the minds of many investors, despite the fact that IPOs in general have poor historical performance. This kind of base-rate neglect involves forming premature assumptions that are based on unrepresentative or filtered information which can lead to the incorrect classification of other kinds of investment opportunities.
Sample-size neglect is a similar type of representativeness bias. Have you ever heard someone tout an investment strategy that generated impressive results over a very short period of time? Assumptions based on very small amounts of data can lead to dangerous overgeneralization; and while someone may have an impressive track record over the past year, extrapolating impressive returns into the future is a common example of sample-size neglect. Results over short periods of time are much more likely to be influenced by beneficial, random outcomes, or “luck,” as compared to results over longer periods of time. Yet many investors assume that small samples accurately describe universal pools of data. 1
In our evolutionary past, and even in our daily lives, intuition and quick decision making can be very helpful; but human nature frequently runs contrary to successful investing. By working with an experienced financial planner and understanding the psychological biases that lead to irrational decisions, you can gain the perspective necessary to improve your investment decisions.
1 Michael Pompian, Behavioral Finance And Wealth Management (John Wiley & Sons, Inc., 2006), 44-74
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.