How to Become a Better Investor Than You Think You Are
Posted by Rick Miller 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:
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.
- We think we are much better than we are at picking investments that will do well.
- We tend to trade too much.
- We want to “do something.” We’re sure we can make things better. Often, however, the best action is no action.
Attribute: Optimism Bias
“We believe that things will work out,’ says David Hirshleifer, a finance professor at UC Irvine.
- Especially when our mood is positive, we may take on more risk than we should.
- When we say “more risk means more return,” we focus on the return rather than the risk.
- We believe that “the market will always come back” after a big decline.
Attribute: Hindsight Bias
In a paraphrase of Belsky, ‘we rewrite our histories to make ourselves look good.’
- We remember our investment (stock picking) successes, and forget the ones that didn’t work out so well. This reinforces our overconfidence and optimism – we “remember” that we made good investment decisions before. Why shouldn’t our investing acumen persist?
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.”
- Again, this bolsters optimism and overconfidence – “even the investments that cratered were essentially good, they failed only due to bad luck.”
- This can lead us to continually seek a “better” advisor: “None of my previous advisors were any good – they all lost me money. I’ll find one eventually who can make the most of my good ideas.”
- The previous advisors really may not have been effective.
- Alternatively, the true culprit may have been accepting a level of risk we didn’t fully understand coupled with a period of poor market returns.
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.
- If we’ve made an investment that doesn’t seem to be working out, we’ll seize on any favorable new information and discount evidence that the investment really is a disaster (or at least a mistake).
- This helps investment scams like Ponzi schemes in general and Madoff in particular hang on long after they should have been discovered – investors ignore early signs of trouble, and only slowly come to realize that they’ve been had.
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
- We don’t have to be good investors to be outstanding people.
- Believing that we are better investors than we are can get in the way of our investment success.
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.