Investing Psychology

The Effects of Behavioral Finance on Investment Choice and Bias

Tim Richards

• Publisher: Wiley
• Year: 2014
• Print ISBN: 9781118722190
• eBook ISBN: 9781118722220
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Discover how to remove behavioral bias from your investment decisions

For many financial professionals and individual investors, behavioral bias is the largest single factor behind poor investment decisions. The same instincts that our brains employ to keep us alive all too often work against us in the world of finance and investments.

Investing Psychology + Website explores several different types of behavioral bias, which pulls back the curtain on any illusions you have about yourself and your investing abilities. This practical investment guide explains that conventional financial wisdom is often nothing more than myth, and provides a detailed roadmap for overcoming behavioral bias.

• Offers an overview of how our brain perceives realities of the financial world at large and how human nature impacts even our most basic financial decisions
• Explores several different types of behavioral bias, which pulls back the curtain on any illusions you have about yourself and your investing abilities
• Provides real-world advice, including: Don't compete with institutions, always track your results, and don't trade when you're emotional, tired, or hungry

Investing Psychology is a unique book that shows readers how to dig deeper and persistently question everything in the financial world around them, including the incorrect investment decisions that human nature all too often compels us to make.

CHAPTER 1
Sensory Finance

Wandering around inside the average investor's mind is very much like taking a tourist bus around Wonderland with the White Rabbit as a guide. Much that we think is obviously true turns out to be false and much self-evident nonsense is rather closer to reality than we could ever have thought.

We're going to start our tour in a place where everyone can “definitely” tell the difference between truth and falsehood, by looking at the way our senses interact with the world around us. Our ability to interact with the world and to learn from it allows us to extrapolate into the future, to make predictions and then to act on those predictions.

Unfortunately, the skills that serve us so well in everyday life combine to betray us in the topsy-turvy world of investing and finance. Our sensory system may keep us alive, but that's no guarantee it's going to make us rich.

BEATING THE BIAS BLIND SPOT

Although it's quite easy to convince people that we're biased in the way we perceive the world, it's very hard to persuade individuals that they are personally just as biased as everyone else. This is pretty irrational—how likely is it that you're the only unbiased person around? Yet there's an underlying reason for this belief and it says that we think we're better judges of the world around us than everyone else. Unfortunately, we're wrong and you are just as biased as me, and I'm just as biased as everyone else. Or I would be, if I hadn't spent a lot of time figuring out how to reduce my biases.

To demonstrate this we can start with a simple visual illusion, such as the one in Figure 1.1, where the two parallel lines are actually the same length, but don't look it. Don't take my word for it; get out a ruler and measure the lines. Remember: don't trust anyone until they've proven they deserve your trust. This trick is known as the Müller-Lyer illusion, and the unsubtle point I'm trying to make is that you can't entirely trust what your brain is telling you about what you see, which then leads to the idea that you can't always trust it about what you think. What the research shows is that it's virtually impossible to make people behave less irrationally until they can be made to accept this. The good news is that once the message gets home there are a lot of things we can do to improve matters. The less good news is that this is hard to achieve; people don't like to think they're biased, even if they're perfectly happy to believe everyone else is.

FIGURE 1.1 The Müller-Lyer Illusion

In fact, the Müller-Lyer illusion has a bit more to tell us about why we're not very good at financial decision making than it first appears. Many of the behavioral biases we meet arise for very good reasons. They're adaptations of our brain's limited processing power, designed to meet the needs of our ancestors, who were generally more concerned about not being flattened by woolly mammoths or mauled by saber-toothed tigers than they were about being fooled by financial advisers. These days, unfortunately, the predators are far harder to spot, although usually they're less hairy and toothy.

Currently, the best theory about why the Müller-Lyer illusion occurs is that it's accidentally triggering our brain's 3D mapping processes, which are tuned to “see” perspective, so we automatically “adjust” the lengths to suit this hypothesis: as Figure 1.2 shows, a real-world interpretation of the illusion suggests we're looking at the corners of a room or a box. In the real world, looking at a 3D scene like this is a far, far more common experience than someone randomly wandering up to us and showing us pictures of lines with arrowheads stuck on the end of them. For this reason, we need to be quite careful about the conclusions we draw from research in this field, because what happens in the laboratory sometimes doesn't match up with what happens in real life.

FIGURE 1.2 The Müller-Lyer Illusion as a 3D Perception

As the Müller-Lyer illusion suggests, you can't even trust what your eyes are telling you because what we see is actually in the brain, not out there in the world, and therefore subject to whatever kinds of interpretation the brain decides to make. In fact, your eyes can't even see everything in front of you. Look at the picture in Figure 1.3, close your right eye, and focus on the + sign, holding the book about 20 inches away from your face. Now move your head towards the book, continuing to focus on the + sign. At some point the dot will vanish.

FIGURE 1.3 + Sign

This is the point at which the image of the dot is falling on the blind spot in your left eye, where the optic nerve enters the back of the eye. Notice that your brain doesn't insert a gap where the dot should be, there's just a continuous blank field—this is your brain automatically filling in the gap as best it can. But what you're seeing is not what is actually there, and we're all affected by this, all the time. What we “see” is constructed inside the brain, based on the evidence of our eyes—but seeing is not the same as believing.

People have a similar problem when it comes to the mental filling in that accompanies behavioral biases: what the psychologists Emily Pronin and Matthew Kugler have dubbed a bias blind spot.¹ You'll happily agree that other people are subject to all sorts of biases, but you'll then argue that you yourself are a better judge of what biases you are affected by—which generally means that you think you can overcome your brain's willingness to fill in the gaps in your knowledge by making wild guesses and hopeful inferences, while simultaneously believing that no one else can.

Well, I'm sorry, but you're not that special. None of us are. Just as we all have a visual blind spot in each eye, which we don't normally notice, and we're all caught by the Müller-Lyer illusion, we're all trapped by the behavioral instincts that guided our forebears so well. The trick is to accept this, and move on—but, believe me, that's harder said than done. This chapter, and the ones that follow it, are about trying to convince you, against all your instincts, that you can't trust your brain, particularly when it comes to financial matters. Our brains have serious money issues, which impoverish us unnecessarily.

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LESSON 1

Don't think that you are immune to the behavioral biases in this book: that's an outcome of the bias blind spot. Everyone thinks that they can overcome this by introspection, but no one actually can, anymore than you can overcome your eyes’ blind spot or the Müller-Lyer illusion.

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ILLUSORY PATTERN RECOGNITION

We use simple processes to navigate our way through life. We look at what happens around us and extrapolate to the future—so most of the time cars drive on the right and people in hospitals wearing white coats are doctors. Unfortunately, this process of relying on personal observation doesn't always work: in Britain the cars drive on the left and doctors in hospitals don't wear white coats—what works at home is often a local rule, not a general one, and this is especially true in stock markets. Get this wrong and you'll get knocked down by a car coming the “wrong” way and struggle to find anyone to treat your injuries.

In particular, we can generate illusory patterns using personal investing experiences, which can cause us to make really stupid decisions because we start imagining we can see trends where none really exist. Visual illusions are a type of illusory pattern, so they're an easy way of showing us we can't entirely trust our instincts and they give us some clues about how our brains interpret information about the world. In Western cultures, one of the most common illusions is the Man in the Moon effect: the perception of a human face peering at us across the void of space. This is an example of a bias called pareidolia, the ability to see order in randomness. Pareidolia gives rise to all sorts of peculiar behaviors, many of which seem to involve images of religious figures appearing in bakery products.

All of this is vaguely amusing, but masks a serious issue. In general, we try to fit the facts to our own preconceptions, rather than theorizing on the basis of the data. We'll see patterns where none really exist, we'll extrapolate on the basis of these illusory patterns, and we'll then wonder why we've lost a ton of money. People who see images of Mother Teresa in a cinnamon bun are using their imagination and memories to “see” the picture. Someone who had no idea who Mother Teresa was would just slather on some butter and eat it.

Illusory pattern recognition is a dangerous behavioral trait where investing is concerned, because much of what investors do is exactly that: we look for patterns. You'll frequently find people commenting on how similar current market conditions are to those from some past period, or see them pouring over charts of various kinds, trying to use them to predict what's going to happen next. This is nearly all based on a perceptual fallacy because the future of investment markets isn't written in the past in ways that can be easily extracted from the data through any kind of simple pattern analysis.

Mostly, though, we don't even bother trying to analyze anything, because we didn't evolve in an environment where we had the benefit of reams of statistics and we had to operate on the basis of what researchers call “observed frequencies”: essentially we looked at what was going on around us and extrapolated from that data. So, if we were unlucky enough to have a family member stomped on by an irate woolly mammoth then we'd conclude that hairy pachyderms were dangerous, and resolve to avoid them whenever possible, a...

Table of contents

• Cover
• Series
• Titlepage
• Copyright
• Dedication
• Preface
• CHAPTER 1 Sensory Finance
• CHAPTER 2 Self-Image and Self-Worth
• CHAPTER 3 Situational Finance
• CHAPTER 4 Social Finance
• CHAPTER 5 Professional Bias
• CHAPTER 6 Debiasing
• CHAPTER 7 Good Enough Investing
• CHAPTER 8 A Few Myths More
• CHAPTER 9 The Final Roundup
• About the Companion Website
• About the Author
• Index
• End User License Agreement