You’ve all heard of the placebo effect, where a patient is administered a fake medicine without knowing and then shows signs of recovery. That’s interesting on its own, but would you believe that they are now running tests where patients are told that the pill they are taking is fake and the results still show improved health? Think about that for a second; people are being told they are taking sugar pills and their minds still help their bodies heal!
Our minds also play tricks on us when it comes to investing. Biases tend to sit deep within our psyche and may serve us well in certain circumstances. However, in financial matters they may lead us to potentially hurtful outcomes. It should be noted that these biases impact all types of investors, both professional and private.
Overconfidence bias is having an inflated view of one’s own abilities. For instance, when asked to rate your ability as a driver, 70% – 80% will say they are above average drivers, although obviously only 50% of all drivers are above average. We tend to look at the world through a positive lens, which may be good in some situations but often harmful for your investments.
Warren Buffet typically begins his annual letter to shareholders by highlighting the stupid decisions he has made and how he has learned from them. There is a lesson to be learned here since most people will view a negative investment outcome as simply bad luck, but attribute a really successful investment to superior skill and knowledge. We don’t learn from our mistakes and, more importantly, we don’t take ownership of them.
One way to correct for this is to write down your mistakes and dissect them to understand where things went wrong. The goal is to get better with future decisions. We can learn much more from mistakes than from victories – this is true of many things in life.
Another interesting bias is loss aversion. The work suggests that investors weigh losses more than twice as heavily as potential gains. If I flipped a coin and offered to pay you $10 if you were right but you had to pay me $10 if you are wrong, would you take that bet? Studies show that the answer is no; people require $25 if they win versus handing over $10 if they lose. Losing $10 is much more painful and outweighs the euphoria you get from winning $10.
We don’t stay up late at night worrying about the investments that did well; instead we grind our teeth about those that lost. This pain from losing stands in our way of making rational decisions with our long-term investment goals.
Moreover, people do not like being associated with losers, so stocks that have performed poorly will largely be avoided. As the chart below indicates, stocks tend to perform their best when investors are feeling the worst about the future outlook. Much like every other purchase in life, stocks are best to buy when on sale, yet we insist on doing just the opposite when it comes to investing.
We are interesting creatures indeed and the mind is a powerful thing. The way we handle our investments is especially fascinating. The pitfalls are well documented yet we still find ways to fall into the same traps, time and time again.