Sensible Perspectives

How to Become a Better Investor Than You Think You Are

Posted by on March 31, 2016

A recent New York Times article by Gary Belsky suggests some reasons “Why We Think We’re Better Investors Than We Are.”
Belsky lists a series of attributes that we all share. These biases affect all parts of our lives, but they have special impact on our financial decisions:

Attribute: Overconfidence

We think that we can do things better than in fact we can. Belsky gives several examples: providing high and low estimates for attributes we don’t know (the diameter of the moon, say), making forecasts (even experts are less accurate than they think they’ll be), and knowing about financial matters.

Investment Implications

 

Attribute: Optimism Bias

“We believe that things will work out,’ says David Hirshleifer, a finance professor at UC Irvine.

Investment Implications

 

Attribute: Hindsight Bias
In a paraphrase of Belsky, ‘we rewrite our histories to make ourselves look good.’

Investment Implications

 

Attribute: Attribution Bias
When things are so bad that we have to admit that they didn’t work out well, we blame the poor outcomes on factors we couldn’t control. Ellen Langer says: “Heads I win, tails it’s chance.”

Investment Implications

 

Attribute: Confirmation Bias
We give extra credence to evidence consistent with our existing beliefs, and little credence to evidence that contradicts those beliefs. This is a major reason that arguments about beliefs can be so frustrating. It’s nearly impossible to persuade our opponents of the validity of our position. We and they are literally working with different sets of facts, or at least with facts that have very different weights attached to them.

Investment Implications

 

All of these attributes are irrationalities. That is, they are not logical (Star Trek’s Mr. Spock would have no sympathy). As a result, they can cause us to make bad decisions – decisions that are not in our best interest.

So, can you do anything to protect yourself from these biases? I have two suggestions.

First, you can inform yourself. If you are a reader, and like big books, I recommend (Nobel prize winner) Daniel Kahneman’s Thinking Fast and Slow as an encyclopedic guide to our irrationalities and some theories about why we might have them. Dan Ariely is an active behavioral finance researcher who writes books and articles for a broad audience. You could try his Predictably Irrational, which has an excellent reputation (I haven’t read it). If you know more about the biases, you may be able to see them in yourself, and combat them.

Second, you can work with an advisor. The advisor will also have the biases Belsky discusses, but they will be different from yours – they won’t be biases about your skills. Most of the biases we are discussing seem to be designed to help us preserve a good opinion of ourselves (both as investors and more generally). However, and very importantly

Most likely, your advisor will be less concerned about your favorable impression of your investing abilities and decisions than you are. And, an advisor who is honest about her own biases and correspondingly humble about her investment acumen may work to limit the impact of bias on her advice to you. With the right advisor’s assistance, you may be able to make more rational, and thus better, investment choices for yourself.

 

 

  • Quentin Regestein

    For those interested in the classic article on decision-making biases:

    Tversky A, Kahneman D. Judgment under uncertainty: Heuristics and Biases. Science 1974;185(4157):1124-1131

    Researchers have shown that:
    1) We tend to be more impressed with a few big wins, than a lot of little ones that add up to more. The same is true of starlings rewarded with a few big vs. many little worms — they will keep trying for a rare big worm rather than more common smaller worms that eventually get them more calories.

    2) The “Sunk Cost Fallacy” (a.k.a. the “Concorde Fallacy”) refers to continuing one’s efforts because you have already put a huge amount of resources into the effort, even though it does not pay. Analysts had said that the Concorde airplane would lose money, but so much effort had gone into producing it, that they built and flew it anyway, until it lost too much.