Behavioral Finance: Looking at the Way Your Thinking and Behavior Affects Your Investing

Ron Wright |

The study of Behavioral Finance helps us understand why we sometimes make choices that seem to be perfectly reasonable and rational, but somehow go wrong.  The truth is that we all have biases and blind spots in our thinking that cause us to behave in ways that can be self-defeating.  This series of posts explores several of the best-known behavioral problems when it comes to investing, as well as thoughts on how to overcome them. 

Part 1 in a series of 5.

Problem: Overconfidence

Overconfidence is a behavior that tempts us to play down the risks and potential pitfalls that really should be considered before making an investment.  It leads us to think that bad things only happen to someone else, not to us, or that we really are so good that the normal risks don’t apply to us.  In his book “The Psychology of Investing”, John Nofsinger gives this great example of overconfidence:

Question: Are you a good driver? Compared with the other drivers you encounter on the road, are you above average, average, or below average? How did you answer this question? If overconfidence were not involved, then one third of you would answer above average, one third would say average, and one third would say below average.  However, people are overconfident in their abilities.  In one published study, 82 percent of the sampled college students rated themselves above average in driving ability.  Clearly many of them are mistaken. 

One of the main causes of overconfidence in people is when they feel they have greater control over the outcome.  Just as in the good driver example, people feel that when they have more control over a situation, they can force the outcome to be better.  This became more and more of a problem during the late 1990’s as online trading became commonplace.  Investors began to feel that once they were making their own investment decisions and placing the trades themselves, they had a much greater chance of success.  This led in the end to some devastating consequences as highly overconfident investors took greater and greater risks simply because they felt that they were in control.

Beyond potential losses, another outcome of overconfidence is the tendency to trade excessively. Overconfident investors tend to believe their decisions will always turn out to be highly profitable; therefore, they tend to ignore things like transaction costs and tax consequences.  By trading excessively, some investors spent more on transaction fees and other expenses than they made through the trades.  Many also forgot to factor in the costs of the capital gains taxes that would become due the next year and found themselves with large tax liability on April 15th!

Overconfident investors also tend to ignore the possibility of losing.  After all, since they must be correct about their expectations, they simply don’t need to consider the potential losses.  But ignoring potential losses does not make them go away.  Professional investors understand that losses can and do happen.  The key is to learn how to minimize those losses, and that cannot be done if they are simply ignored.

Yet another dangerous aspect of overconfidence is bad behavior being reinforced through accidental successes. During the late 1990’s, it seemed that all it took to make money was to pick any small internet startup company and throw all of your money into it. Investors who took this path often invested in companies selling what was referred to as “vaporware”, a product that had not yet even been fully conceived let alone profitable. When the prices for those companies rose (before the dot-com bubble burst), it reinforced the belief in those investor’s minds that they had an innate ability to make good picks.

Problem: The Illusion of Knowledge

The illusion of knowledge is a behavior that leads directly to overconfidence but deserves some individual attention itself. The illusion of knowledge is the tendency to believe that more information leads to greater accuracy in decision making. This can be a very dangerous line of thinking in today’s world where the internet can provide more information than we could ever possibly hope to comprehend – and much of it dubious at best. Again, Nofsinger provides an excellent example:

...if I roll a fair, six-sided die, what number do you think will come up, and how sure are you that you are right? Clearly, you can pick any number between one and six and have a one-sixth chance of being right.  Now let me tell you that the last three rolls of the die have each produced the number four.  I roll the die again.  What number do you think will come up, and what is your chance of being right?

Different people may have a different reaction to that additional knowledge.  Some may think that the number four is more likely to come up since it has so often before.  Others might think that the number four has run its course and another number is due.  In fact, if it is a fair die, there is no greater or lesser chance of the number four coming up than any other number each time the die is cast – the odds are still one in six.

In investing, the illusion of knowledge comes from analyst opinions and reports, tips from friends or colleagues, and even internet chat rooms.  It is crucial to remember that not all information provides a true and complete picture of any situation.  The failures and bankruptcies of several high-profile lenders during the credit crisis testifies clearly to that.  Keep in mind that they used to call the folks from Enron, “…the smartest people in the room.” Most investors had no idea what they were really holding in those investments, simply because they were not given all of the facts.  Many were led to believe they were buying safe, low risk securities only to find they no longer had the ability to sell them because the market for them had simply vanished.

Another source of the illusion of knowledge is in the academic world.  In 1994, a group of “super investors” formed a hedge fund known as Long Term Capital Management.  Lest you think I am making too much of the level of academic knowledge involved, two of the founding directors won the Nobel Prize in Economics in 1997 for their research in determining the value of stock options.  These were the very men who made options trading possible.

The fund did at first experience fantastic returns - almost 40% annually. But by late 1998, overconfidence on the part of these managers had led them to take massively over-leveraged positions in foreign government debt.  When the Russian government defaulted on their bonds, those highly leveraged positions collapsed as well, leading to huge losses.

Eventually the Federal Reserve had to get involved, organizing a bail-out by a consortium of banks in order to avoid a wider collapse of the debt markets.  All of those great minds were eventually led astray by their own knowledge and success.  They failed to clearly see the risks involved in what they were doing, simply because they were so supremely confident in their own abilities.

Overconfidence and the illusion of knowledge can lead us to take risks and make choices that would otherwise seem irrational.  They key to avoiding those pitfalls is to ensure a disciplined, reasonable approach to investing.  While we all seek to get the best returns on our money, we always need to be aware that there is no way to totally eliminate risk.  The key is to manage the level of risk that we take, and not to ignore it simply because we don’t want it to be there.  It is also critical to be sure that the sources of information we use are both credible and correct, so that we are not fooled by false "knowledge".

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