Medical practitioners make important, sometimes life-saving decisions each day because they are highly trained professionals. Yet when it comes to financial decisions, doctors, and most other humans, make many mistakes, most of them avoidable. As noted in an earlier section, a big part of the answer is human psychology. Our psychological biases put us in danger, because:
This combination often makes us our own worst enemy.
One bias I’ve already mentioned is procrastination, which often arises due to our psychological need to escape anxiety. When a source of anxiety arises—for example, the need to grapple with a financial decision—our minds find relief by ignoring the need to make the decision, i.e., by putting the decision off. When the problem inevitably comes up again it causes even greater anxiety because we have even less time left to make the decision.
Below are some other biases and factors that affect our decision making.
Overconfidence and the Illusion of Control
In his book, Your Money & Your Brain, Jason Zweig addresses overconfidence when he states that “One of the most fundamental characteristics of human nature is to think we’re better than we really are.” As an example, in a roomful of 100 people, he notes that 75 percent will raise their hands when asked if they believe they are better than the average person in the room, regardless of what they’re supposed to be better at: telling jokes, driving cars or playing basketball. Needless to say, 75% of the population cannot be better than average. It has also been well established that men tend to exhibit greater overconfidence than women.
Analogously, we exhibit tremendous overconfidence when it comes to love and relationships. Statistics tell us that 50% of marriages will fail, but when asked about the probability of our own marriage failing we all swear that our risk is at most 10% and most likely 0%.
In the financial decision-making context, overconfidence leads us to believe we’re able to: see real patterns in markets where no one else can, consistently pick winning stocks, and correctly estimate probabilities of complex events.
As documented by Malcolm Gladwell in a New Yorker article, the illusion of control occurs when one’s “confidence spills over from areas where it may be warranted … to areas where it isn’t warranted at all.”
People who are reasonably successful in other arenas often assume they’ll be successful as investors. They believe their position in society somehow gives them an edge, which will inevitably lead to investing success. They invariably realize (often painfully) just how little control they have in financial markets.
The illusion that success or competence in one area implies success elsewhere has been dispelled in numerous scientific articles. Among the earliest contributors in the field were psychologists William Chase and Herbert Simon, who studied chess players and established that expertise in chess did not necessarily translate into expertise elsewhere.
Despite overwhelming evidence, we seem unable to recognize our own overconfidence or to identify and shake the illusion of control. Often, we believe our actions give us control over financial markets when such confidence isn’t based on reality.
As investors we may resort to superstitions such as consulting our horoscope or invoking a prayer before launching stock market transactions. Neither of these acts affects the probability of our investing success, but they make us feel more confident, convinced that divine intervention is now working on our behalf. There are many analogies to this in sport. For example, a baseball pitcher may touch his cap three times before each pitch, while a batter may tap his bat against his shoes in a set sequence before setting up in the batter’s box.
In the investing realm, market professionals often take advantage of our tendency to fall for the illusion of control. Consider firms touting their latest online trading platforms. Their advertisements flash colorful, three-dimensional graphs, tables and heat maps intended to look glamorous and sophisticated. Their pitch is designed to plant in our minds the idea that their product will give us greater control over financial markets and an edge over everyone else. In reality, of course, none of this glitz helps us to make better investments—it only makes us believe the illusion that we are getting an advantage.
When it comes to financial markets, humility is your best guide. Ego will lead you astray.
The Endowment Effect
The endowment effect refers to the observation that most people appear to place a higher value on an object or investment after they’ve taken possession of it. Ziv Carmon and Dan Ariely document this phenomenon in the Journal of Consumer Research. The researchers interviewed two groups of students who had expressed an interest in a lottery allocating scarce tickets to a Duke University playoff basketball game. One group was composed of students who failed to receive tickets through the lottery. When contacted by researchers, members of this group expressed a willingness to pay an average price of $166 per ticket. The other group was composed of students who did receive ticket allocations through the lottery. Members of this group expressed a willingness to sell their tickets for an average price of $2,411 per ticket.
The study confirmed the hypothesis that people attribute higher value to an asset they own than the value attributed to the identical asset by those who don’t own it.
In the investing context, this at least partly explains why we’re reluctant to sell assets we already own. In our minds we associate a high, possibly sentimental, value with these holdings and we don’t want to part with them.
Separate your emotions from investment decisions. They mix badly.
In his seminal book, A Random Walk Down Wall Street, Burton Malkiel states that “Losses are considered far more undesirable than equivalent gains are desirable.” In other words, the pain of losing is more powerful than the pleasure of gaining. Scientists have estimated that a given loss is about twice as undesirable as the same magnitude of gain is desirable. This phenomenon is known as loss aversion.
This psychological bias is at play when we own an asset whose value declines. Reluctant to realize an emotionally painful loss, we convince ourselves that the asset’s “fair” value is higher, and we often decide to wait for the price to appreciate to a more “appropriate” value before we sell (fair and appropriate here are subjective values on which we’ve fixated). Deferring the sale allows us to avoid the anxiety of formally recognizing the loss. We convince ourselves that if we just give it a bit more time, the price will recover. But as we wait, the price declines further and further.
Lenders also suffer from loss aversion. Consider a bank that lends money to a business, and then the business takes a turn for the worse. Rather than writing off the loan and walking away, the bank feels an obligation to recoup the initial loan and agrees to lend more to the bad borrower. The borrower then promptly proceeds to mismanage the second loan. Now the bank has lost even more money. The bank’s loss aversion decision is often referred to as “throwing good money after bad.”
The rational approach is to ignore past losses, sometimes referred to as “sunk costs,” in making current decisions, but psychologically that doesn’t come naturally to us.
Adhere to an investing strategy (preferably a passive one) that prescribes when you buy and sell. Don’t deviate from those dispassionate instructions.
In their book, Sway: The Irresistible Pull of Irrational Behavior, authors Ori and Rom Brafman define value attribution as “Our inclination to imbue a person or thing with certain qualities based on initial perceived value.” For example, we’re likely to conclude that an impeccably dressed advisor with an impressive office is more capable than a shabbily dressed fellow with a small dusty office. Similarly, we may believe a company with a beautifully designed annual report is a superior investment to a firm with a more basic document.
In the medical setting, we are predisposed to assume that a person with a white coat and stethoscope is an authority—on everything. Value attribution predisposes us to assume the professor from the more prestigious university must be correct or that a stock tip is more credible when overheard at a country club as opposed to the YMCA. Jumping to conclusions based on such attributes can set us down the wrong path.
Don’t allow value attribution to influence your decisions. Gauge advice-givers’ relevant expertise very carefully.
Physicians are trained to think for themselves. But when it comes to financial decisions they are susceptible, like the rest of us, to following the crowd. Many factors make us conform and copy what others around us are doing. Among others, these factors include greed, fear of missing out, and peer-pressure. We can’t stand the idea that others are getting wealthy while we stand on the sidelines, so we jump in even when reason tells us it’s a bad idea.
This mentality encourages financial bubbles. It gave us unrealistic valuations for tulips in 17th century Netherlands, and every other asset bubble up until the 21st century Dot com and real estate bubbles. It’s very difficult to stand against the majority when that majority appears to be making a lot of money with little effort. We all want part of that action. We feel like fools when we appear to be the only holdouts.
Inevitably, drawn in by the collective euphoria, we invest when the market nears its peak, and soon thereafter we suffer large losses when the bubble bursts.
Think for yourself and remember that if something seems too good to be true, it likely is.
Confusing Causation and Correlation
Many people confuse causation and correlation. They don’t realize that an observed event or action may appear to cause another, when in reality the two events simply happen to coincide. This leads to humorous assertions that Nicolas Cage movie appearances are related to, and perhaps cause, pool drownings, or that ice cream sales cause more shark attacks. In the former case the data is purely coincidental while in the latter there is an underlying weather driver: during the summer ice cream sales are higher, and more people swim in the ocean, providing more targets for shark attacks.
As scientists, doctors understand the difference. Patients’ improved health doesn’t automatically mean a drug treatment should be credited with success and claims that flu vaccine causes flu shouldn’t be believed without evidence. In all cases data should be carefully examined before causality is declared.
Mistaking causation and correlation can be very damaging in the world of finance. We often buy stocks due to an incorrect assumption that we understand what drives their value. Subsequently, we’re disappointed to discover that the assumed relationship doesn’t hold and our investments lose value. In our complex financial markets, it’s possible to find many relationships between observed variables and stock price movements. The problem in most cases is that these relationships may be fleeting, or may reflect correlation but not causation. Nevertheless, our intuition leads us to assume causality, thereby putting our money at risk.
At all times remember that financial markets give us only incomplete glimpses of data. Resist the inclination to believe you can see patterns and relationships within the chaos.
Selective Confirmation or Diagnosis Bias
When we selectively seek evidence to confirm our preconceived notions and beliefs, rather than accepting all evidence regardless of where it points us, we are guilty of selective confirmation or diagnosis bias. An investor influenced by selective confirmation bias highlights only those investing outcomes that match her preconceived notions about market movements and investment value changes. By ignoring similar investments with opposite (negative) outcomes, she selects the evidence to match her beliefs. Since the evidence embraced is not objective, it’s likely to lead to poor investing decisions.
Medical professionals are well aware of the dangers of these biases, because they’re ever present dangers in medical research settings. But they generally aren’t on guard for psychological biases during financial planning. This undermines the quality of financial decisions.
As a scientist, you’re already trained to be well-aware of these biases. Remember they apply both inside and outside your laboratory.
Inexperience is not a psychological bias, but it does affect the quality of decision making. By definition, beginner or amateur investors lack the experiences of professional investors, and may initiate a quick, impulsive investment without having a complete sense of what is going on.
We can link this discussion to the notion of intuition. Neuroscientists view intuition as a pattern-seeking process in which past experiences stored in the brain’s “database” are subconsciously matched with current situations. When a “match” occurs, it results in an inclination to take some action, even if we can’t put the reasoning into words. The larger our brain database, the more likely we are to find a helpful match. An inexperienced person has a small database with fewer good matches to be found, and is more likely to take misguided action after accepting a “match” that isn’t well-suited to the situation.
More than most professions, doctors understand the importance of building a large store of knowledge and developing intuition. Internships and residencies are geared to providing intense and complex exposure to medical ailments and treatments. Immediate feedback from senior colleagues increases the rate of learning, helping young doctors to create large brain medical databases.
But as part-time investors, doctors don’t get that intense learning. This leaves their investing databases sparsely populated, making them more likely to make mistakes.
In some sense, the worst case scenario arises when an inexperienced person has early success as an investor. This is because his small database then has very few, and skewed, experiences which further boost his overconfidence, making him more likely to believe he has an ability to see patterns in chaotic financial markets and to pick out winning investments.
We see lack of experience all the time in the context of financial bubbles. Anyone who begins investing after the last bubble burst has no memory of the downturn, and therefore no appreciation for warning signals that more experienced investors would notice. The longer it takes for a bubble to form, the larger the cohort of people whose databases lack sobering experiences.
The Dot com bubble which burst in 2000 and the home ownership bubble which slid off a cliff in 2008 both formed over the course of about eight years. In each case, tens of thousands of young investment bankers, traders, financial advisors, risk managers, brokers, loan officers, insurance agents and mid-level managers had never experienced a serious loss.
In their collective store of patterns, value increases were the only possible outcome for assets. The larger the cohort of investors who feel invincible, the bigger the bubble, and the deeper the crash when their mortality is revealed.
A sobering thought: We are now on an unprecedented, decade-long, bull-run. How far will markets drop when the next decline inevitably occurs?
If you’re an inexperienced investor, stick to the tried and true passive strategy. Playing any other game puts you at a considerable disadvantage compared to professional market participants.
Decision making takes place within the brain, and therefore anything that affects the brain affects our decisions.
Our brain functions may be adversely affected by aging, disease or other physiological factors such as fatigue or chemical imbalance and depletion. Any of these may lead to sub-optimal decision making.
Ensure neither you, nor an aging parent, is making financial decisions with a biologically disadvantaged brain.