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September 20, 2005

Living In Lake Wobegon

In talking about why Investment Returns Don't Mean Diddly last week, I demonstrated the massive negative affect of our emotional biases on investor return. This week I'd like to elaborate a bit on what those biases are and how they manifest themselves.

 

Here is a brief summary of some of the more obvious effects:

 

Self- Attribution Bias

This bias causes us to give credit for our successes to ourselves but to blame our losses on others or bad luck. As a result, we fail to learn from our mistakes because we don't see them as mistakes and we assume we are skilled or smart when the reality is we're just lucky.

 

The Gambler's Fallacy

We have all heard a sportscaster talk about a "streaky hitter" or a basketball player who has missed three of his last four free throws. The gambler's fallacy is that just because a player missed three of his last four that he is more likely to miss the next one. We are hard-wired to spot trends in random events and then to add insult to injury, believe they will persist.

 

Prospect Theory

Research finds we are much more distressed by prospective losses than we are happy about equivalent gains. In other words, we feel losses much more sharply than we do our gains. This results in a tendency to sell winners too early and hold on to losers too long.

 

Conservatism Bias and Confirmatory Bias

Once we form opinions, we tend to give more weight to information that reinforces our position and dismiss information that undermines it. We will also tend to actively seek out supporting information . Thus, we irrationally cling to incorrect conclusions, and, to paraphrase Simon and Garfunkel, hear what we want to hear and disregard the rest.

 

Over-optimism

We tend to be overoptimistic and overconfident. It appears we all live in Lake Wobegon, where "all the children are above average." When you ask a group of people how many of them are above-average drivers, the vast majority will say they are above average. When you ask a couple how much of the housework each of them performs, the answer will almost always total more than 100%. We over-estimate our abilities, under-estimate risk and exaggerate our ability to control uncontrollable outcomes.

 

Outcome Bias

We tend to evaluate decisions based on outcomes instead of probabilities. As a result, we congratulate ourselves for stupid choices that happen to turn out well and vow to never again make smart choices that happen to turn out badly. It is because of outcome bias that they say the worst thing that can happen to a new investor is that they make money right off the bat. Suddenly they think they are a genius!

 

Buffett's "Rearview Mirror"

We base our expectations for the future on what has happened in the recent past. Thus, we are most bullish at the end of long bull markets, when we should be most bearish, and most bearish at the end of long bear markets, when we should be most bullish. Those who have made their fortunes in the financial markets, including Warren Buffett, have demonstrated the consistent ability to do the opposite, which is to buy when everyone else is irrationally selling and sell when everyone else is irrationally buying.

 

Hindsight Bias

When we reflect on the past, we imagine that we knew what was going to happen when we didn't. As James Montier puts it, "You didn't know it all along, you just think you did." We are all gifted with 20/20 hindsight, which we incorrectly translate into the ability to predict what will happen next.

 

Expert Bias

We tend to defer to the perceived expertise or authority of others even when it goes against our best judgment. This effect is most famously illustrated in the experiments of Yale professor, Stanley Milgram, who demonstrated that normal people were consistently willing to deliver lethal levels of electric shock to a subject in deference to an authority figure.

 

People's natural tendency is to view the conclusions of behavioral finance as proof of how dumb everyone else is rather than how dumb we all are as we try to outwit the market and each other. Oh, to live in Lake Wobegon where our biases would actually be truth!

 

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Posted by Kim Snider on September 20, 2005 | Permalink

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