Behavioral Economics and Investing

Brian Hicks

Updated June 15, 2010

As speeches go, Alan Greenspan’s presentation to the American Enterprise Institute in 1996 was a long one.

“The Challenge of Central Banking in a Democratic Society” contained 4,335 words that only an economist could possibly sit through without getting sleepy.

To say that it was a bit dry is something of an understatement… Boring is more like it.

But of all of the words that he uttered on that night over fourteen years ago, two of them have managed to live on long after he finally turned over the microphone.

Buried deep within the night’s lecture there were the words irrational exuberance — a full four years before the dot-com bubble burst, costing investors $5 trillion in the process.

Those two words turned out to be much more than a mere warning that stocks were in danger of being overpriced; they also helped to turn the idea of the efficient market hypothesis right on its head.

Behavioral economics and investing

A rational market? Well hardly, according to Greenspan.

On this score he couldn’t have been more right. After all, behavioral economics and investing go hand in hand.

Looking back, it was about the only thing he got right.

Because as we have now learned in dealing with two massive bubbles in only ten years, first in tech and then in housing, the markets are not rational at all — at least not in the short run.

As Greenspan implied, there is a ghost in the machine. As a result, things aren’t always as they appear to be — especially when it comes to the markets.

The reason for this, of course, is simple: Markets are made up of people.

And of all the things that people tend to be when it comes to their investments, irrational is near the top of the list. Irrationality is what leads to losses.

But by understanding how and where your reasoning can go astray, you can help to build up your portfolio by simply choosing to limit your losses on far more of those “irrational” losers — or even better, by not selling your winners too soon.

The key here, though, is in learning to recognize the cognitive biases that have handicapped your investing in the first place.

I call them my “Eleven Reasons Why What You Think is Probably Wrong.”

Learning to recognize these things can save you a ton of heartache, but only if you’re honest with yourself.

The eleven emotional hurdles that could be killing your portfolio

  1. The Bandwagon Effect: This is the one that causes the most pain in a bubble. It’s the idea that it’s okay to follow the herd because so many other people believe in it. It’s irrational because it places its faith in the safety of numbers, while completely disregarding the fundamentals. Without it, a bubble is impossible.

  2. Loss Aversion: People to have a strong preference for avoiding losses over acquiring gains. It’s the fear that puts them on the sidelines to stay.

  3. Disposition Effect: This is the tendency for investors to lock in gains and ride out losses. It prompts the sale of shares that are rising, while at the same time keeping investors tied to losers for far too long. It’s closely tied to loss aversion, since it’s the fear of loss that dominates the thinking.

  4. Outcome Bias: Judging a decision by its outcome rather than the quality of the decision at the time that it was made. This is what makes investors completely disregard a proper decision if it turns out to be a loss.

  5. Sunken Costs Effect: Treating money that has already been spent as more valuable than money that may be spent in the future. It’s what helps to build up losses because the investor believes that by selling at a loss he is wasting money. That same money could be put to use elsewhere.

  6. Recency Bias: Weighting recent data more heavily than earlier experiences. It’s what freezes investors — especially after a series of losses — even though there may be a much longer string of successes in the past.

  7. Anchoring: This is the tendency for people to rely too heavily on readily available information when making a decision. Investors often base their decisions on information that may be faulty.

  8. Belief in the Law of Small Numbers: This is when investors base their conclusions on a slice of data that is too small. It’s the equivalent of making mountains out of molehills, and it blurs reality.

  9. Endowment Effect: People tend to value something more once they own it. As in housing, people tend to overvalue what belongs to them. Of course, this only blinds to them to the real value.

  10. Disconfirmation Bias: This makes people critical of information which contradicts their beliefs while uncritically accepting information that is in line with them. In short, it’s a trap whereby people believe what they want to believe.

  11. Post Purchase Rationalization: This when investors persuade themselves through rational argument that a purchase was a good value. Of course, if a decision needs to be rationalized after the fact… it is probably wrong.

Individually, of course, all of these biases are dangerous. Taken together, they are the stuff that bubbles are made of.

Guarding against them in the future may be the one of the best investment decisions you’ll ever make.

Mr. Greenspan did manage to get one thing right before he drove the bus off the cliff: The markets really can be irrational.

As for places where the next bubble might be found, I think we are in the early years of what I believe will be the biotech century. A troubled world economy aside, this is one sector where the right disruptive discovery could earn you a small fortune.

After all, it’s only rational.

Your bargain-hunting analyst,

steve sig

Steve Christ
Editor, Wealth Daily

P.S. If you enjoyed this article, be sure to read my 15 Can’t-Miss Rules for Stock Picks, published two weeks ago. It’s a look at what I’ve learned in over 25 years of watching the bulls and the bears battle it out — and some lessons, I’m sorry to say, were learned the hard way.

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