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HUMANS ARE WIRED in ways that, alas, aren’t conducive to achieving our financial goals. Indeed, thanks to research by academics focused on behavioral finance, we now have a much better handle on the money mistakes that many of us regularly make. Want to become a better investor? Here are three insights into ourselves, compliments of behavioral finance:
The illusion of understanding. Once you’re aware of this illusion, you start seeing it everywhere, especially in the financial media.
In his book The Black Swan, Nassim Nicholas Taleb relates what happened in the financial markets on the day Saddam Hussein was captured. Bond prices initially rose, prompting Bloomberg’s news service to post the following headline: “U.S. Treasuries Rise; Hussein Capture May Not Curb Terrorism.” Thirty minutes later, bond prices fell. Bloomberg came out with a new headline: “U.S. Treasuries Fall; Hussein Capture Boosts Allure of Risky Assets.” Same news, two different headlines. Hmmm.
Financial markets are complex. Most of the time, they can’t be explained by a simple headline or story. So why are we drawn to these articles? Because humans are uncomfortable with uncertainty and complexity. We want a simple narrative. We need the world to make sense, to be coherent. The media simply supplies what we crave.
The illusion of understanding is not only powerful, but also dangerous. When we start to believe the stories that we tell ourselves—based on half-baked truths—we greatly oversimplify reality. In so doing, we can fall prey to two biases, one pertaining to the past and the other to the future.
First, we delude ourselves into thinking that we knew it all along. “Of course, the financial crisis of 2008-09 was inevitable. I saw the writing on the wall.” Or perhaps: “I just knew the market was vulnerable in early 2020. If only I had acted on my intuition.” Such hindsight bias prevents us from learning the lessons of the past. It also leads us to regret our earlier actions or inaction.
Second, our simplified narratives delude us into believing that the future is more knowable than it is. I’ll call this the forecast bias. Forecast bias explains why we hang on every word uttered by financial gurus, particularly their predictions. Hindsight bias and forecast bias both feed another of our behavioral shortcomings—overconfidence.
Wisdom begins with intellectual humility, namely understanding the boundaries of our knowledge. We could all learn from the approach of physicist Richard Feynman, who said, “I think it’s much more interesting to live not knowing than to have answers which might be wrong.”
Regression to the mean. In Thinking, Fast and Slow, Daniel Kahneman offers the following bit of wisdom: Success = talent + luck, while great success = a little more talent + a lot of luck.
One of the hardest concepts for people to grasp—but also one of the most important—is regression to the mean. It’s a slippery concept, and also totally counterintuitive. Without delving into statistics, I’ll simply posit the following: Any time the correlation between two events is imperfect, there will be regression toward the mean.
Kahneman relates a story about teaching flight instructors from the Israeli air force. He told them that rewards for improved performance work better than punishing mistakes. (Parents will likely find the same applies to child rearing.) One flight instructor countered that his teaching experience suggested the opposite. The flight instructor observed that, when he praised a cadet’s outstanding performance one day, the next day the cadet’s performance would usually suffer. Meanwhile, if he scolded a cadet for lousy performance, the following day the cadet would show improvement. In other words, criticism led to better performance and praise to worse results.
How does this relate to regression to the mean? Day-to-day performance is not perfectly correlated. Performance = talent + (some) luck. One day a cadet just nails it. The next time he attempts the same maneuver, he is likely to do worse, simply because of regression to the mean. The converse is also true. A particularly bad performance one day is more than likely to be followed by a better one. The flight instructor was finding causality between feedback and subsequent performance where none existed. It was simply a case of regression to the mean.
Seeing causality where none exists, while failing to appreciate regression to the mean, can also be found in the world of investing. For instance, years of outperformance by a mutual fund manager should be followed by years of subpar performance, but that isn’t what we expect. We assign far too much weight to the manager’s talent and too little to luck. Result? We buy funds after hot streaks and sell them after performance inevitably cools, the opposite of what we should do if we understood regression to the mean. We repeat this mistake with asset classes, market sectors and individual stocks. A better understanding of regression to the mean would do wonders for investor behavior.
Narrow framing. How information is framed has a huge impact on how we behave. Humans are narrow framers by nature. We focus on the trees and ignore the forest. This manifests itself in many ways, but I’ll focus on just one example—how we look at our portfolios.
We narrow frame our portfolio in the dimension of time. What do I mean by that? Rather than view our performance over long time periods, such as five or 10 years, we might focus on the monthly statements we receive. Many of us—me included—also look at our portfolio on a daily or weekly basis.
But work by Shlomo Benartzi and Richard Thaler has found that when investors are shown long-term rates of return, they invest more of their retirement savings in stocks. In other words, risk tolerance is directly affected by how frequently we check our portfolio. This effect has been termed myopic loss aversion. By taking a wider frame, we would be more willing to accept greater risk and ultimately garner higher returns.
We also narrow frame when we examine our portfolio’s individual holdings. While our overall performance is certainly of interest to us, we are often drawn to specific holdings, our eyes frequently focusing on the “losers.” This preoccupation is an example of loss aversion: Losing investments give us greater pain than our winning investments give us pleasure.
Loss aversion can lead us to tinker with our portfolio, dumping the laggards and adding to the winners. But the truth is, a well-diversified portfolio will almost always have both losers and winners. This lack of correlation among our holdings—which leads to a calmer overall portfolio—is exactly what we’re seeking when we diversify, but narrow framing blinds us to proper portfolio management. One of the (many) advantages of target date funds: By giving us a diversified portfolio in a single mutual fund, they prevent such narrow framing.
John Lim is a physician and author of How to Raise Your Child’s Financial IQ, which is available as both a free PDF and a Kindle edition. His previous articles include Six Lessons, Risk Returns and Crash Course. Follow John on Twitter @JohnTLim.
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