We tend to inaction, to overvalue our knowledge, or to be persistent in our mistakes. Would you like to know 7 ways in which your mind betrays you when investing, so read this post.
Homo economicus is the Alexa or Siri of neoclassical economists. An elegant modeling of human behavior. It is always pursuing its own interest sensibly and rationally. A robot that responds to monetary stimuli with the precision of an algorithm. The human being is far from being that perfect decision-making machine. Often, we make the wrong choices. We make decisions that harm us. Also, we do not choose the easy way. And, we do not properly calibrate risks, nor do we value all the alternatives we have.
For forty years, the branch of knowledge known as behavioral economics has developed. It is a hybrid between psychology and economics. It studies how people act when making economic decisions. Rather than theorizing about how they should behave. The full rise of this branch of knowledge was the award of the Nobel Prize in Economics. In 2002, it was given to Daniel Kahneman, one of its leading theorists.
Among the great advances in behavioral economics, is accurately finding system failures. We all trick ourselves when making decisions that affect our wealth. Those trucks are called behavioral biases. They make us act unreasonably, and make many decisions that go against our interests. This is clearly a great risk in times of high uncertainty.
7 ways in which your mind betrays you when investing are:
1. Overconfidence bias
People think we are smarter than we are. We think we know how things work, but we only have a superficial idea.
“The overconfidence bias is one of the most pernicious out there. It may lead you to find failure unlikely” explains María Eugenia Cadenas Sáez. An analyst in the financial education area of the National Securities Market Commission (CNMV).
In the financial arena, confident people underestimate the risks of their decisions. At the same time, they overestimate the expected gains. This leads them to make excess purchases, incurring high transaction costs. This reduces profitability. They end up having not sufficiently diversified investment portfolios.
A good example of this bias is about driving. Drivers out in the street were asked about their driving abilities. 94% answer that they drive as average or better than average. This is obviously impossible.
This failure is closely linked to the bias of illusion and excess of optimism.
2. Confirmation bias
“See, what I was saying.” With this short phrase we could describe this trap of our mind.
“Confirmation bias involves selective evidence collection. We only pay attention to those who agree with our thesis.” Says Cadenas.
Someone may consider technology companies are too complex to investing in. So they will be aware of any news or report that reinforces their thesis. When a technology company announces a downward revision of its income, it’s their moment. They will say: “You see now? you can’t trust it.” They usually have the hardest time admiring they may have been wrong. The world’s most famous investor, Warren Buffett (Berkshire Hathaway’s largest shareholder) did it. “I’ve been an idiot for not having invested in Apple before,” he came to admit.
This failure in the system is closely connected with the anchor bias. It consists of giving more weight to old information than to new information that contradicts it. These previous ideas sometimes represent real anchors, difficult to release. In the investment world, this bias is frequently seen. When the profitability of an investment product is presented first, so that other information is not taken into account.
3. Social proof bias
A few acquaintances are investing in preferred shares of the savings bank. It rents 5%, so, why shouldn’t I? Social proof bias is the tendency to imitate other people’s actions. It is believing that the correct behavior is to adopt.
In Spain, there have been massive investments in preferred shares. And the status quo bias implies the current situation is taken as a reference point. Any change from that point is perceived as a loss. A very clear example is what happens with pension plans. The majority of savers do not choose to change plans.
4. Authority bias
What our neighbor or brother-in-law does influences us. But also the opinions of important people. Authority bias is the tendency to overestimate the other people’s opinions. And doing it for the mere fact of being who they are. The mistake is in not subjecting them to prior prosecution.
On Monday, February 28, 2020, the well-known economist José Carlos Díez (close to the socialist party and whose name even sounded like a possible Minister of Economy) wrote on his Twitter account:
“Don’t you know where to investing your savings? Telefónica buys at € 5.39 per share,”
At that time, the Covid-19 pandemic was already hitting Italy. It had quietly infiltrated all of Spain.
10 years before, those titles were trading at 17 euros. Also, José Carlos Díaz is a professor of economics at the University of Alcalá de Henares. So it might seem like good advice. However, four months later, Telefónica’s shares are trading almost 20% below. The price at which Díaz recommended buying vanished. Listening to famous people is not always recommended.
Another good example is when you use the statements of Nobel Prize winners. Even if it has nothing to do with the branch they were awarded in. There have been openly racist noble winners. Also, they have declared conspiracy, or outright nonsense statements. The discoverer of HIV, Luc Montagnier, has defended the use of homeopathy. And this is a pseudo-therapy systematically discredited by the entire scientific community.
5. The halo effect
It is the tendency to judge a person or institution. But doing it on the basis of a single positive or negative quality. Overshadowing all others. It is a very frequent bias in the investment field. A financial product tends to be classified as good or bad based on a single data. The results of a company or its popularity may depend entirely on its marketer or manager. People don’t consider that this financial product may not be suitable. They ignore the intended investment objective or for their own risk profile.
Confusing the notoriety of a brand or a product with its solvency or profitability potential. Thus, investors have a preference for investing in companies of brands they know. Especially when they are from their own country. How can Banco Santander not go well? They have an incredible number of branches. And their owners are powerful. However, reality shows many times that this notoriety does not have to be linked to profitability.
6. Hyperbolic discount
We love sayings. Concentrated wisdom. Infallible. “A bird in the hand is worth two in the bush”. It depends. What if I had some way to catch them both? Even if it was only 10%. The hyperbolic discounting bias is the propensity to choose smaller, immediate rewards. This happens because the immediacy of the rewards has a great power of attraction.
The hyperbolic discount can lead the investor to undo an investment designed for the long term. They ignore an eventually attractive evolution of the markets. Thus altering the initial objectives and entailing associated costs and risks. Analyzing odds, threats, and rewards is not always easy. But you should do it.
7. Sunk Cost Fallacy
This mental trap is especially bad for gamblers. When they have lost a lot of money, they think the best is to keep playing. Big mistake. This bias leads us to maintain an investment that is generating losses. Those affected fear losing what has already been invested. In those moments, you have cold blood instead. Analyze if the company is going to be able to recover. Do not take into account the lost money.
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