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April 2016 Newsletter - Why Investors Think They Are Better Than They Are

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Let us first apologize to any lawyers who may be reading this. The New York Times article this is based on was sent to us by a client who actually is a lawyer, so it must be OK. If it makes you feel better, you could in each case replace the word “lawyer” with “educated professional”.  

 

Behavioral finance is a tremendously interesting discipline that attempts to describe “judgment under uncertainty” and “decision under risk” Every day, global securities markets provide researchers with billions of data points for understanding how people make choices when resources are at stake and the outcome is unknown.

 

Which, if you think about it, is a fair description of most decisions. Consider the “sunk cost fallacy,” a primary reason Dan, an unhappy lawyer might struggle to leave law and Catherine, an unsuccessful investor might balk at selling money-losing shares.

 

Both people are highly likely to obsess over their sunk cost — law school tuition and time served for Dan, the original investment amount for Catherine — in an unconscious desire to justify their earlier decisions.  Both are also very likely to fall prey to “loss aversion,” a key tenet of Prospect Theory, which tells us that humans typically respond to the loss of resources — be it time, effort, emotion, material goods or their proxy, i.e., money — more strongly than they react to a similar gain.

 

What differentiates Dan and Catherine, however, is their justification for engaging in their activity.  Lawyers are trained to do what they do, while the majority of investors are not. Ask a random player in a law firm’s basketball league whether he or she could compete with LeBron James, and the most common response will be laughter.  Yet many of those lawyers would willingly compete in investing with the billionaire investor Warren E. Buffett.

 

Despite the spectacular growth of index funds — passive investment vehicles that track market averages and minimize transaction costs, along with professional advisors, millions of amateur investors like Catherine continue to actively buy and sell securities regularly. This despite overwhelming evidence that amateur investors dramatically underperform the market indices and the performance of professionals.

 

Money managers, at least, are paid to research and make investment decisions. So, why do amateurs believe they can outperform the professionals? Many biases and cognitive errors contribute to this costly behavior, but a few deserve mention.

 

Overconfidence

 

Try these challenges:

Give high and low estimates for the average weight of an empty Boeing 747, picking numbers far enough apart to be 90 percent certain that the true answer falls somewhere in between. Now, give high and low estimates for the diameter of the moon. Again, choose numbers far enough apart to be 90 percent certain that the true answer falls somewhere in between.

 

Come up with a range for each so you could confidently bet $9 against the prospect of winning $1.

 

As it happens, an empty 747 weighs nearly 400,000 pounds, or 180,000 kg, and the diameter of the moon is roughly 2,200 miles, or 3500 km. But research involving these and similar problems suggests that for most, these answers do not fall within your high and low estimates. That’s because most people do not realize how little they know about the subjects or how difficult it is to bracket estimates as requested.

 

Instead, people come up with what they believe to be logical estimates of the plane’s weight and moon’s diameter, then they adjust from those figures to arrive at their brackets. But unless you work for Boeing or NASA, your initial estimates are probably going to be wildly off the mark, so the brackets should be wider— say, from one pound to one billion pounds for the plane’s weight and from one mile to a billion miles for the lunar diameter. That most people do not default to such broad ranges reflects a trait that behavioral economists call overconfidence. This is not run-of-the-mill arrogance, but rather the tendency we all have to overrate our abilities, knowledge and skill, at whatever level we might place them.

Studies have revealed significant overconfidence in the judgments of scientists, lawyers, engineers, doctors and those in other professions. The University of Pennsylvania psychologists Philip Tetlock and Barbara Mellers collected more than 25,000 forecasts from people whose job it was to anticipate how the future would unfold. All demonstrated remarkable overconfidence. When they were 80 percent sure of their predictions, they were correct less than 60 percent of the time.

 

Optimism Bias

 

Overconfidence is hard-wired into our brains because it is useful. Many of our mental biases evolved because they make us cautious or they otherwise protect us from harm, but overconfidence is part of a suite of cognitive traits that serve to propel us forward. Just as no one would think to write a children’s book about a train engine that repeats, “I think I can’t,” few explorers would venture into the wild — and few entrepreneurs would start new businesses — unless they believed that they would succeed in the face of long odds.

A bias toward optimism helps to explain why Doug, a smoker, is confident that he will not develop cancer; why Jackie is certain that her texting will not lead to an accident; and why many investors believe they can outperform the market. “We are evolutionarily programmed to believe that things will work out,” said David Hirshleifer, a finance professor at the University of California, Irvine.

 

Hindsight Bias

 

More confounding than the existence of investor overconfidence is its persistence: as markets teach us costly lessons, we should grow humble.  But the fact that many do not reflects what Professor Hirshleifer describes as self-enhancing psychological processes.  One of the biggest esteem builders is hindsight bias, or the tendency to rewrite our own history to make ourselves look good. In landmark experiments by the psychologist Baruch Fischhoff, then at Hebrew University, study participants were directed to make predictions about real-life events, then were asked periodically to recall the events and their predictions after the fact.  His findings?  Participants consistently misremembered their forecasts, in ways that made them look smarter.  In other words, when Diane is telling you about her recent massive stock market win, she may truly not be remembering all “the ones who got away”.  Too often we look back not in anger but in awe, at least of our own capacities.

 

Attribution Bias

 

Of course, many people easily recall failures, which suggests that hindsight bias is not all that powerful. But even when our failures remain vivid memories, we remember them in a way that neutralizes their ability to inhibit our present-day decisions. When events unfold that confirm our thoughts or deeds, we attribute that happy outcome to our skills, knowledge or intuition. But when life proves our actions or beliefs to have been wrong, we blame outside causes over which we had no control — and thus maintain our faith in ourselves. The Harvard psychologist Ellen Langer describes the phenomenon as, “Heads I win, tails its chance.”

 

Again, with apologies to the legal profession and others mentioned, the study of Behavioral Finance is fascinating and attempts to explain illogical and/or irrational decision making with respect to investing.  The thought we leave you with is this: an expert in the field of investing is less likely to make costly emotion based decisions with your money.  Just as a doctor is better able to diagnose your symptoms or a lawyer is better able to ascertain the strength of a law suit, an investment advisor is better able to offer reasoned advice for your financial wellbeing.

 

Agree? Disagree? Do any of the behaviours above remind you of anyone? Tell us what you think. Contact us here.