Thursday 5 January 2012

We Are Not Programmed to Invest Successfully

Being human means that we have inbuilt behaviour patterns that make us poor investors. So, if you do 'what comes naturally' the results will be disappointing. 
While we like to think of ourselves as rational in our decision making, the truth is we are subject to many biases. Being aware of them will give you a better chance of making fewer investment mistakes.

1) Over-confidence: Even those who acknowledge how difficult it is to beat the market believe that they'll be among the chosen few who can. Here's a test for your intuitive powers (do it quickly):
  • a bat and a ball cost £1.10
  • the bat costs £1 more than the ball
  • how much does the ball cost? (see below)

2) 'Forecaster illusion': Because our brains try to 'make sense' of everything in hindsight, forecasters who got lucky are perceived as skillful, leading to the illusion that they have the ability to make valid predictions. In fact, not only are there no good forecasters, but forecasters persistently overestimate their ability to get it right.

3) 'Possibility effect': This causes us to vastly overvalue the probability of highly unlikely events. Do you buy a lottery ticket? Or small growth stocks?

4) 'Certainty effect': This leads us to vastly underestimate the likely outcome and therefore to overpay to eliminate the small possibility of highly unlikely negative events. Would you pay extra for investments that offer a guaranteed return of principal or a guarantee related to inflation or market performance?

5) 'Hindsight bias' and 'Outcome bias': We tend to blame decision-makers for good decisions that worked out badly, and to give them too little credit for successful moves that appear obvious only after the fact. Are you a good decision-maker? Because we see the world as more tidy, simple, predictable and coherent than it really is, we can easily confuse strategy with outcome. Hindsight and outcome bias generally foster risk aversion. But they also bring undeserved rewards to irresponsible risk-takers who take crazy gambles and win.

6) Loss aversion: The pain we feel from losses is much greater than the joy we feel from equal-sized gains. So, closely following the daily fluctuations of the market (which on average are fairly equal doses of loss and gain) will make you feel bad and the more likely you will be to make a poor decision. To a point, the less you look at your portfolio, the more successful an investor you're likely to be.

7) Confirmation bias: We all tend to look for support for our own ideas, and prefer to ignore conflicting evidence.

8) Recency bias: Recent events tend to weigh more heavily in our minds, even if they don't really deserve to. Are you a 'momentum' investor?

9) Survivorship bias: For every long-term corporate winner, dozens have fallen by the wayside. We don't hear much about the losers, but focusing only on the winners gives us a false picture.

10) Illusion of patterns: Perhaps one of the greatest in-built faults when it comes to investing - we are programmed to find patterns, even when none exist (we all have a 'Beautiful Mind' to a certain extent, if you have seen the film).

One of the most important writers on investment behaviour is Daniel Kahneman, an Economics Nobel Prize winner; his book Thinking, Fast and Slow is worth a read for anyone interested in either human behaviour or investing. The review here  (Larry Swedroe/CBS)introduced me to some of the concepts above. 

What can you do about it?

Well, awareness of our potential failings helps. But also the DIY Income Investor approach may help to overcome this evolutionary programming:
  • we don't rely on forecasters or tips
  • there is a clear, fairly simple strategy (and choices are constrained)
  • there is plenty of evidence that the approach works in practice
  • we are not trying to 'beat the market' but rather to generate a reasonable income at reasonable risk
  • the strategy is based on steady growth and income generation, rather than 'quick wins'
  • because it is a mainly 'buy and hold' strategy, there is no need to be constantly reviewing the portfolio and checking on performance
  • there is less emphasis on the value of investments and more on the income stream generated, allowing a longer-term view to be taken more easily

Do you agree? Are there any other behavioural investment biases we need to be wary of?

(By the way, the answer to the question in point 1 was not 10p, which many people intially come up with, but 5p.)

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.


  1. All good advice.
    But, if a statistic I read that the top 3% of rich elite have most of their wealth in stocks, shares and bonds (for, there is only a "certain" amount of personal property which is able to be economically maintained...), then we are clearly missing something. Here is a formula:
    Get rich. Get stinking rich. Invest MOST of your money in the largest, oldest best established commodities and companies in the world. SOME in prospective, high earning medium-risk capital; and SOME in dynamic new markets (after doing a great deal of research...).
    Not bad for somebody who's never owned a share !

  2. Thanks, really good analysis.

  3. Yes, I also appreciate that the analysis of the article is good. We are not a programmer or analyst, who can make investment successful.