One of the key assumptions of classical economic theory is that individuals behave rationally and act in their own economic self-interest.
It is believed that we all make economic choices based entirely on an unbiased interpretation of the related facts, a clear understanding of how volatile the future is, and a fair evaluation of our own beliefs and skills.
In a world full of casinos, Ponzi schemes, and £25,000 trainers, it is easy to see that the assumption of economic rationality is not an accurate depiction of the way humans actually behave.
But what causes individuals to consistently make decisions that are not in their own economic self-interest?
As the British philosopher Bertrand Russell put it: “It has been said that man is a rational animal. All my life I have been searching for evidence which would support this.”
Fortunately, research in the field of behavioural economics has uncovered several identifiable psychological biases that help explain these irrational tendencies.
Overconfidence is probably the most common of the behavioural biases, and it is the easiest to understand because we recognise it in those around us every day (even though we usually fail to recognise it in ourselves).
Overconfidence refers to people who tend to believe, without any formal training, that they are experts in such wide-ranging fields as geopolitical strategy, fantasy football, and stock picking.
Overconfidence leads many investors to believe that they can outsmart the stock market by timing the ups and downs of the market or by picking stocks to outperform the market, despite numerous past failures and overwhelming academic evidence that these practices are almost always counter-productive.
As economist Ken French has said, “Overconfidence is almost certainly the most important bias in behavioural finance. But most people still think I’m not talking about them.”
When you are caught in traffic and you are incessantly changing lanes, only to find that the lane you just exited is flowing quickly now, you are experiencing activity bias.
In a stock market context, activity bias is harmful because it drives investors to trade too frequently and to feel stressed if they are inactive when markets are either skyrocketing or sharply declining. Studies have shown that investors who trade less frequently tend to outperform those who trade more often, but activity bias makes disciplined investing less likely.
Self-attribution arises out of our need for self-esteem, and while it is a separate bias in its own right, it also leads to overconfidence.
The investment world is full of amateurs, as well as professionals, who are adamant that their stock-picking strategy would have been a big success had it not been for an extraordinary streak of bad luck that nobody could have seen coming.
Despite abundant historical evidence to the contrary, they remain confident that with just a couple of minor tweaks it will be successful next time.
Recency bias, also known as extrapolation, is the tendency to project the recent past into the future.
This tendency to feel bold after a good result and fearful after a poor result is certainly understandable from a psychological perspective, but a rational investor should be a more willing buyer after prices have fallen, and vice-versa.
These irrational biases have served humans well from an evolutionary standpoint, and they aid us in many areas of our everyday lives.
For example, overconfidence is helpful for entrepreneurs and politicians, activity bias encourages goal-directed behaviour, self-attribution bias protects our (often) fragile self-esteem, and recency bias reminded our ancestors to stay away from the tall grass because the last guy that went over there got eaten by a tiger.
Unfortunately, these biases are not well-suited to investing.
Human psychology almost always drives investors to overestimate their investing ability and to trade too frequently and often in the wrong direction. Worse yet, these biases cannot be eliminated; they are a part of our most basic human nature.
However, it is possible to construct a financial plan and an investment strategy that account for these tendencies. And recognising the existence of these biases allows you to understand how they impact your financial thinking.
We may never be able to eliminate bad investment behaviour, but we can use our understanding of it to ensure a successful financial future.
Interested in knowing more?
If so, here’s what I’d like to offer you: a (virtual) cup of coffee and a second opinion.
By appointment, I would be delighted to have a chat with you about your situation. I will ask you to briefly outline your financial goals – in other words, what you hope your investment portfolio will do for you. Then, I’ll review your strategy with you.
I look forward to hearing from you!
Amyr Rocha Lima, CFP® is a partner at Holland Hahn & Wills LLP, a financial planning practice based in Kingston upon Thames. He specialises in working with successful professionals age 50+ helping them reduce taxes, invest smarter and retire on their terms.
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any financial products.