Believe it or not, all investors are not entirely rational. Well, that doesn’t seem so hard to believe. But understanding common patterns of investor irrationality may help you become a better investor.
The Nobel Prize committee recently added some weight to this by awarding the economics prize to two college professors in the United States who have been pioneers in explaining how human behavior and investing interact. The work of award winners Daniel Kahneman at Princeton University and Vernon Smith at George Mason University, among others, deserves to be read by all serious investors who want to learn how to recognize their own biases and faults.
For instance, Kahneman broke ground over 20 years ago by identifying a behavior known as “myopic loss aversion.” The concept is simple: he found that investors are more averse to selling a stock at a loss than selling it at a profit. But this unwillingness to realize a loss can hurt investors in cases where it is more logical to take a loss and deploy their money elsewhere.
“Hindsight bias” is another common problem for investors who believe the past will repeat itself almost immediately. This leads them to favor the types of investments that have done well recently, even though winning streaks enjoyed by individual asset classes always come to an end. Such behavior prompted many investors to throw money into technology stocks in early 2000 just as the four-year tech stock boom was at an end. And it probably has many investors putting new cash into bonds this year, even though bonds have had a three-year run and are at their best levels in many years.
Yet another bias is overconfidence. Studies have shown that the majority of drivers believe their own skills are above average, even though accident statistics show that can’t be true. These investors credit themselves with investment skills they don’t have, and tend to trade too frequently.
There is controversy over whether these theories can help an investor identify securities that other investors have “mispriced.” However, investors certainly can recognize these biases themselves and learn to avoid making bad investment moves or following irrational strategies when making decisions.
