The time has come for me to do an exercise that I have wanted to do for quite some time. No….not crossfit. I play real sports, I don’t look to be the best at exercising…I am talking about doing a series of posts that take into account our cognitive biases and how they affect our investment decisions. Biases and cognition’s have been studied for decades, however, only recently has there been an in depth study of our decision-making process and how it relates to our investments. The study of behavioral investment management is somewhat new and now en vogue, as seen in Michael Lewis’s new book The Undoing Project….(Sorry Nick Murray)… Where he dives deep into the relationship between psychologists Daniel Kanahmen and Amos Tversky. These two men are generally lauded as the fathers of decision making science. One of their most famous studies was Prospect Theory…(Nobel Prize…Nobel Prize!!). Basically, stating that people choose between probalistic alternatives that involve risk where the probabilities of outcome are known. In layman’s terms and in terms of investing this means people make decisions based on the potential value of gains and losses rather than the final outcome and people use their own heuristics (mental gymnastics) to justify their decisions. This can be seen daily as investors make risk averse or risk taking decisions with their investment portfolios.There is a ton of literature on the subject and there are people far more educated than me in the field of behavioral psychology. However, as a money manager and a Psychology Major I find their work extremely helpful when trying to understand some of the behaviors of my clients and the investment public in general.
The focus of today is confirmation bias, otherwise known as my side bias. Confirmation Bias speaks to the tendency of people to search for and interpret information that confirms their own pre-existing beliefs. Sound familiar…….the entire cable news industry is based around Confirmation Bias. Why do you think Conservatives love Fox and Liberals MSNBC? It’s not because of the independent journalism or spiffy info-graphics, it is because these organizations confirm pre-existing beliefs. Why else would each sub-set of opinions believe they are right and the other is wrong and reference either Fox/MSNBC as evidence. It is almost quite comical how transparent it has become….. But today we are here to talk investing not politics and specifically how we can avoid allowing our pre-existing beliefs to hurt our investment portfolio.
It is quite easy to fall in down the worm hole of Confirmation Bias, we are human after all. Unfortunately, for many of us being human is the problem. If we were all computer programs we would not hold these biases, or at least not yet. The perfect example of letting pre-existing biases directly affect your investment portfolio can be found in market extremes. When the market is rallying along we tend to look for research that confirms the rally, eschewing any data that may say otherwise. Especially, if we are long the market. We know intellectually that the gravy train can’t run forever, yet we still place heavy bets on risk assets and toss aside diversification. The same goes if we are in a bear market and are short or out of the market. We will look for anything that justifies us being on the sidelines and hope and pray that the tide does not turn positive anytime soon. Can you imagine the sleepless nights of investors acting like this. The FOMO (fear or missing out) or the fear of striking out has to be palpable.
The problem is that markets rarely trade in extremes. Subsequently, I have found that when presented with compelling data that speaks to an outcome you’re not prepared for or that does not fit your narrative the most biased of the bunch get quite defensive. Just take a look at a CNBC octobox the next time the S&P sheds 20 points on a Tuesday, its almost become the only thing worth watching. The producers of CNBC know this, they love market extremes and I am sure their ad sales department loves them even more.
As investors both amateur and professional we need to be aware and prepared for all potential outcomes and we achieve this through diversification. Not just diversification of our portfolio but diversification of our information sources. Reading data or news that only confirms what you believe is not only harmful, it is downright ignorant. We all need to keep our confirmation bias in check… the fate of our portfolio depends on it……
If you’re uncertain on how your portfolio is allocated or just need a diversification review, please contact me for a free portfolio consultation…
Stay Diversified My Friends,