Emotions and Biases Play Huge Role in Bad Investment Decisions

In a recent New York Times article, columnist Gary Belsky observes that “the majority of cognitive biases and shortcuts that influence everyday judgement and choice have analogues in investment behavior.” In other words, insights from behavioral economics and finance explain why people don’t often behave rationally when investing. For example, amateur investors believe they can outperform the professionals, largely because of cognitive biases. The article highlights several, such as overconfidence and optimism biases, as described below.

Overconfidence bias is the tendency to overrate one’s abilities, knowledge, and skill. Mirtha Kastrapeli of State Street described overconfidence found in a 2014 study: “Nearly two-thirds [of surveyed investors] rated their financial sophistication as advanced” she stated, continuing: “Th[e] disconnect between actual and perceived financial sophistication is evidence of how widespread the overconfidence bias is.” David Hirshleifer of UC Irvine explains optimism bias: “we are evolutionarily programmed to believe things will work out” regardless of evidence to the contrary.

Other biases are also relevant. Hindsight bias causes people to rewrite their history in order to be cast in a more positive light, which can prevent investors from correctly remembering their failures, often leading to similar, equally unwise financial decisions. “As markets teach us costly lessons, we should grow humble. But the fact that many do not reflects what Professor Hirshleifer describes as self-enhancing psychological processes,” according to Belsky. Attribution bias occurs when people recall their failures in a way that prevents inhibition of present decisions. “When events unfold that confirm our thoughts or deeds, we attribute that happy outcome to our skills, knowledge, or intuition. But when life proves our actions or beliefs to have been wrong, we blame outside causes over which we had no control — and thus maintaining our faith in ourselves,” Belsky says. Confirmation bias prevents investors from seeing their own incompetence. It leads them to give too much credit to information that supports previously held beliefs and ignore that which does not. “Even if investors are not rewriting history or blaming outside forces, they are still highly likely to miss signs of their own incompetence,” Belsky explains.

Professor Hirschleifer advises “self-distancing” to address some of these biases. It involves pretending you are viewing your own situation at a distance. He also suggests considering the opposite side of any transaction before making it.  This approach was also recommended by Thomas Gilovich of Cornell University, but he takes it a step further: “Something more specific and guided is likely to be more effective, like conducting a ‘pre-mortem,’ ” he said. “The idea is to suppose that your idea bombed. What would you be saying to yourself right now about how or why you should have foreseen it?”