The most recent recipient of the Nobel Prize for economics was Richard Thaler for his work in pioneering behavioural economics.
His research showed people do not always make rational decisions. This contradicts economic theory which relies on people making rational decisions.
His studies showed people often make decisions that don’t serve their best interests and do so consistently. He brought economics and the psychological analysis of decision making together.
I find the psychology of investing or behavioural investing endlessly fascinating. Here’s part II of arcinvest’s analysis of Behavioural Investing.
Confirmation bias
Confirmation bias is the tendency to favour and remember information in a way that confirms a pre-existing opinion or belief. Information presented is assessed and interpreted in a manner that favours your existing position. People also tend to interpret ambiguous evidence as supporting their existing position.
Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence.
Explanation for the bias include wishful thinking, limited human capacity to process information and people weighing up the costs of being wrong, rather than investigating in a neutral, scientific way. Poor investment decisions due to these biases are often found.
If you hold a stock it is perceived as being more valuable to you since you made a decision to purchase it. Therefore, in spite of evidence that your original reasons for purchasing it have changed, you look for reasons to continue to hold the stock even though it may now have gone up so much it’s over-valued or the companies situation has changed e.g. new competitor, changed management. You will actively look for reasons to hold the stock to justify your original decision.
Anchoring Bias
Anchoring is the tendency to rely too heavily on the first piece of knowledge gained (the “anchor”) before making a decision. Once you have an “anchor”, other judgments are made relative to that anchor.
Anchors such as previous highs or lows for a share should be ignored. The purchase price you paid should also be forgotten. “Sunk costs are forgotten costs” should be a mantra when trying to maximise your returns. The price paid once the decision has been made and executed should have no part about any rational future decision with that investment.
As Charlie Munger of Berkshire Hathaway said, “A lot of people are trying to be brilliant. We’re just trying to be rational.”
We all come loaded with Biases, but engaging someone independent such as a good financial advisor can help you acknowledge and overcome many of these behavioural biases when it comes to investing.
Recommended further reading
“Nudge: Improving decisions about Health, Wealth and Happiness” by Richard H. Thaler
“Thinking, Fast and Slow” by Daniel Kahneman