This post will explore how your brain impacts investing and what to do about it. But first, here is our disclosure:
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Investing and being rational
When I was in college, I took Economics 101, where I learned about traditional economic theory for the first time. One of the key points of this theory is that people are rational. To this day, I cannot get my head around this idea.
I remember looking around the classroom and asking myself, “Is this professor referring to us as rational?” Has he not seen college students on a Friday night? How can anyone base an entire theory on people being rational?
But wait, it gets better!
Since traditional economic theory thinks we are all rational, it also believes people change their opinions based on new information. I do not know about you, but that is not my experience with myself or anyone else.
Instead, we often harden our stance when we feel challenged. We dig in and refuse to adjust our beliefs in light of new information. It’s called “getting defensive,” and it is a superpower of all humans.
I am convinced whoever created this theory must not be from planet Earth! They must have never read the news or left their house, which would not be rational. So, I guess you can say that traditional economic theory is irrational. It relies on an ideal person that doesn’t exist in reality.
This leads me to ask: “Where can one find these mythical humans that traditional economic theory is based on?”
Beautifully Irrational
Let’s face it. Humans are emotional and act in irrational ways. We have a hard time accepting that we are wrong. Moreover, we tend to seek information and people that align with our views and opinions.
This is why our success at handling money and investing depends much more on our behavior than our math skills. We are not perfectly rational beings. This is where behavioral economics enters the scene.
Behavioral economics is one of the most valuable investing concepts I have come across. It helps us to understand our tendencies and biases. It embraces our irrational behavior in all its glory, giving us better insight into how we make investment decisions.
So, what exactly is behavioral economics?
What is behavioral economics?
The field of behavioral economics combines economics and psychology to gain a deeper understanding of how individuals make financial decisions. Unlike traditional economic theory, behavioral economics does not adhere to the belief that we are all perfectly rational with complete self-control. In other words, behavioral economics does not believe we are all emotionless robots.
Behavioral economics embraces the idea that humans can be emotional trainwrecks, leading us to make bad decisions. It accepts us for who we are, not some ideal version that it hopes we will be. That is what makes behavioral economics so valuable for us as investors.
The following three books are a valuable resource for understanding the impact of emotions on investments.
By understanding how our emotions and biases impact our decision-making, we can become more self-aware and make better decisions with our money. So, what does behavioral economics say about our ability to make sound investment decisions? It all starts with our competing thought processes.
Two Ways of Thinking
Daniel Kahneman won the Nobel Prize in Economics for his work on the impacts of psychology on economics. He is considered one of the founders of behavioral economics. In his book “Thinking, Fast and Slow,” Daniel Kahneman introduces two ways of thinking. He calls them “System 1” and “System 2.”
System 1 is quick and automatic. It makes decisions fast without much thought, relying on past experiences, intuition, and emotions. System 2 is slow and deliberate, requiring time and effort to reach a logical decision. Each system of thinking serves a purpose.
Making decisions using only System 2 would make getting ready for work in the morning time-consuming. Every step, such as brushing your teeth, tying your shoes, and locking the front door, would require conscious and deliberate effort. System 1 makes these actions automatic, which helps get us to work on time. However, that quick and automatic thinking can get you into trouble when you apply it to investing.
Making impulsive decisions with our money is never good, but that is what many of us do. Too often, we rely on System 1 instead of logical System 2 when making investment decisions. This leads to rash choices based on emotions, intuition, and biases. Cognitive biases are mental shortcuts that System 1 likes to take, and they can get us into trouble.
So, let’s dig in and look at several cognitive biases and how they are hazardous to investing. This is not an exhaustive list of biases, but these are some of the most significant ones. It all starts with being too self-assured.
Investing Hazard #1: Overconfidence Bias
I hate to break it to you, but I am the best driver on the road, or at least that is what I believe. And if I had to guess, millions of drivers in the US believe the same thing about themselves. That is because most of us suffer from overconfidence. We believe that we are above average in almost everything we do. This is called overconfidence bias.
Overconfidence bias refers to the tendency for people to overestimate their abilities. Overestimating your ability as an investor can lead you down a dark, scary path.
Overconfident investors trade more frequently and concentrate their money on high-risk investments. This excessive trading and lack of diversification usually results in underperformance rather than overperformance. But instead of learning from our mistakes, overconfidence bias lets System 1 off the hook for its rash decisions.
When things go wrong, an overconfident investor may place blame on other people, institutions, or world events. It is the big corporate greedy banks, Jim Cramer, the Republicans or Democrats (depending on which party you associate with), or the Fed’s monetary policy.
By blaming everything and everyone, overconfidence bias lets pesky System 1 off free and clear. It prevents us from seeing and learning from the flaws in our decision-making process. In doing so, it perpetuates the cycle of bad decision-making.
Investing Action Items
A certain level of self-awareness is needed to avoid falling prey to overconfidence bias. We need to be honest with ourselves and our abilities. To do this, it is essential to seek information and perspectives that challenge your viewpoints. You also need to change your mindset surrounding the word “average.”
Be average to outperform
In our society, calling something “average” is akin to using a four-letter curse word. But there is nothing wrong with being average. In fact, being average might make you a great investor.
It is difficult to beat the market. Many try. Most fail. Think about it this way: actively managed mutual funds often trail their indexes, even with investment professionals at the helm. I would wager that most fund managers are overconfident in their abilities and still come up short. Therefore, you may achieve better results by trying to match the market than by trying to beat it.
You can match the market by investing in low-cost, broad-market index funds or ETFs, such as an S&P 500 index fund or a total market index fund. I will admit that investing in these funds will only make your returns “average.” But you will benefit from keeping things simple and stop yourself from overestimating your abilities. Remember, matching the S&P 500 or a total market index can have you outperforming most actively managed mutual funds over the long haul.
This is not to say that you should never take risks or buy individual stocks. However, keeping them to a small percentage of your portfolio is probably best, lest overconfidence bias takes over and wreaks havoc.
Play Money
I know the urge to beat the market all too well, and overconfidence bias will come calling no matter how hard you try to avoid it. Your ego does not like taking a back seat.
One way to satisfy this urge is to set aside “play money” or a “play fund.” This is money you can afford to lose. It lets you take chances on a speculative investment without impacting your long-term goals. You can safely satisfy your ego without jeopardizing your financial well-being.
Learn More
I highly recommend “The Little Book of Common Sense Investing,” by John C. Bogle, who founded The Vanguard Group and is credited with creating the first index fund. This book shows how a simple, low-cost S&P 500 index fund might be the smartest, most powerful, wealth-generating investment someone can make. The book is available through the Amazon affiliate link below.
Investing Hazard #2: Confirmation Bias
Confirmation bias causes us to seek information that confirms our beliefs and brush aside information that may challenge them. It feeds our hungry overconfidence bias, creating tunnel vision. You can become convinced that an investment is a sure thing and lose sight of the risk. I fell into the trap of confirmation bias when I bought into AT&T years ago.
Confirmation bias in action
I wanted to take up a position in a stable dividend-paying stock. I stumbled across an article that mentioned AT&T. That is when the beast known as confirmation bias took over.
Instead of searching for terms like “great dividend-paying stocks” or “Is AT&T a bad investment,” I only searched for terms that confirmed my view of AT&T. I tuned out all other information and became laser-focused on only those articles that matched my opinion. I convinced myself that AT&T was an excellent buy. It was a no-brainer.
I bought AT&T and watched it trade flat for years. The dividend did nothing to help my returns. Whenever I thought of selling, I read another article explaining why AT&T was a great buy and how it would bounce back. So I kept holding it. Eventually, I would stumble across behavioral finance and decide to cut it loose.
Confirmation bias can also have the opposite effect. Instead of convincing yourself that an investment is a sure thing, confirmation bias can play off of your fears. In a down market, you can convince yourself that the market will never come back.
The sky is falling
During periods of economic upheaval, confirmation bias can work against you. You can become convinced that “this time is different” and the markets will never recover. I know people who stopped contributing to their 401Ks during the bear market in 2022. They convinced themselves that inflation was here to stay and bought into the fear pushed by the media. The same was true of the Great Recession.
In the aftermath of the Great Recession, there was doom and gloom everywhere you looked. If you believed “it is different this time,” there was no shortage of news outlets pushing that narrative. This caused many people to stop investing in the market. Worst yet, many went so far as to sell off their investments.
However, what followed the Great Recession was the longest bull market in history. Those who confirmed their fears through news outlets peddling fear missed some of the best opportunities to invest in the market. And confirmation bias kept them out even as they saw the market rising.
You might wonder how anyone missed the start of the longest bull market in history. It is simple. During that time, there was an overabundance of negativity everywhere you looked. Talking heads, media, family, friends, and neighbors dismissed any upward trend in the market. So people did not have to work hard to confirm their views.
Always remember, no matter how well the economy is doing or not doing, there will always be a chicken little screaming that the sky is falling.
Investing Action Items
The key to overcoming confirmation bias is to seek new information and perspectives that challenge your viewpoints. Engage in continuous education through books, reliable news sources, podcasts, and courses. The goal is to keep System 1 in check and System 2 engaged. Ongoing and active learning does just that.
Make it a daily habit to read a little each day. I like to wake up early and start my day by reading personal finance books on my Amazon Kindle for about 30 to 60 minutes. Then, I go for a run and digest what I read. If you are short on time, try dedicating 15 minutes daily to the activity. Fifteen minutes a day adds up to over 90 hours a year.
What should you do if we find ourselves in another Great Recession?
Shut off the news. Don’t give into the fear. Keep investing. You built a well-balanced, diversified portfolio for these exact times.
Tools that can help
I love my Amazon Kindle. It is my tool of choice to counter confirmation bias. The Kindle makes reading books easy. It can also store thousands of books at your fingertips. To make things better, many public libraries loan Amazon Kindle books for free.
To learn more, check out the Amazon affiliate link below. I only endorse products and services I use and like. The Kindle is one of those products.
Investing Hazard #3: Hindsight Bias
Hindsight bias is the tendency to overestimate your ability to predict an outcome based on past events. It can be summed up by the saying, “Hindsight is 20/20.”
Hindsight bias completes the trifecta of biases. It causes people to overestimate their abilities (overconfidence bias) and look for information supporting their views (confirmation basis). If you want to see hindsight bias in action, sports talk radio is where it’s at.
Hindsight Bias in action
I get a kick out of listening to the passionate football fans venting their frustrations on the radio after a New England Patriots loss. These fans criticize the playcalling or question why the team did or did not go for it on fourth down. Little do they know, they are suffering from hindsight bias.
It is easy to criticize the playcalling once you know the outcome of each play and the game. The best position in all sports must be the Monday morning quarterback. Hindsight bias personalities, a.k.a. sports personalities, get paid millions of dollars to provide their opinions on sporting events that have already occurred. However, their hindsight bias does not make them any better at predicting the outcome of future games.
Think about all of the people who lose money gambling on sports. I would bet (pun intended) that many of them are the same radio callers complaining week in and week out after each loss. They love grumbling about losses as if they knew the outcome all along, but when they have to predict the outcome of a game before it is played, they stink at it.
Many investors are like the football fans who call sports radio stations complaining about the outcome of a game. It is easy to think they knew how things would turn out when they look at past events. But, past events do not predict future results, and no one can predict the future.
When you read up on the housing bubble and the Great Recession, you might be in disbelief that no one saw it coming. Likewise, when you observe a stock you have been following, either rise or fall, you might convince yourself that you knew what would happen.
Investing Action Items
A fun activity is to predict where your investments will be after one week, one month, six months, and one year. Then, log the actual price of each investment after each interval and compare it to your predictions.
This activity will demonstrate how difficult it is to predict the future price of your investments. By recording and comparing your price predictions, you prevent using hindsight bias to rewrite history. You can do this exercise with any investment or stock, whether you own it or not.
Another effective way to overcome hindsight bias is to maintain an investment journal. In this journal, document the reasoning behind each investment decision you make. Jot the reason down right away, not weeks or months later. Make sure to include investments you were seriously considering but chose to forgo, as they are just as important as the ones you decided to pursue.
This investment journal will prevent you from using hindsight bias when reviewing your investment decisions. It will also keep your ego in check. With your ego in check, hindsight bias can no longer encourage overconfidence bias to become a party animal and wreck your finances.
Investing Hazard #4: Loss Aversion
Loss aversion is the tendency of people to feel the pain of a loss more than the pleasure from an equivalent gain. In other words, we do not like to lose. Since we feel a loss much more than a gain, it can lead us to make bad investment decisions.
The pain of losing money on an investment can cause people to cling to a losing investment instead of selling it. They may hope the investment will recover, and any signs of progress may keep them tied to it. They might even think, “I’ll sell once the stock price returns to what I paid for it.” The issue with this thinking is that the stock price may never rebound, and you may lose out on better opportunities.
On the other hand, some people may sell a profitable investment too soon. They don’t want to lose their gains, so they quit while they’re ahead. While they may have made money, they missed out on further gains by pulling out too soon.
I know firsthand how powerful loss aversion can be. One of my very first stock picks was Alcoa. I held on to this mediocre stock for ten years in large part due to loss aversion. I could not push myself to sell for over a decade, even as I saw the gains of the S&P 500 blowing it away. This is the pinnacle of loss aversion.
Investing Action Items
If you invest in individual stocks or securities, try to ignore the price you bought them at when deciding to sell. Fixating on the purchase price tends to cause us to hold onto losers too long and sell winners too soon. Instead, compare the underlying business to the current stock price.
Ask yourself: “Would I buy it now at its current price, regardless of what I originally paid? Your answer to this question will help guide you in your decision.
Answering this question helped me make the painful decision to sell my investment in Coinbase at an 80% loss. I had bought into Coinbase at the peak of the crypto craze and rode it from over $300 per share down to $55 per share before selling. While on the way down, I even purchased more shares, believing they were bound to go back up.
Another way to counter loss aversion is to limit your exposure to individual stocks and speculative investments. You do this by building a well-balanced, diversified investment portfolio you can buy and hold through good times and bad times. From there, you can branch out and take small risks on individual stocks without jeopardizing your financial future.
Learn More
Understanding how we think and make decisions is crucial for investing and personal finance. In his book “Predictably Irrational,” Dan Ariely provides valuable insights into the reasons behind our decisions. He argues that although our decisions may not always be rational, they are often predictable. I highly recommend reading this book to learn more about this fascinating topic.
Summary
Behavioral economics is one of the most important concepts I have ever come across. It provides invaluable tools and insights into your decisions surrounding investing and money.
Once you discover behavioral economics, you won’t be able to go back. You will begin to apply it to all aspects of your life, not just finances. As a result, your decision-making skills will improve more than you can imagine.
The key concept behind behavioral economics is that people are not always rational. We have tendencies and biases that impact how we invest and manage money. Understanding these biases and the psychology behind our decisions can make us better investors.
The ultimate goal is to keep System 1 in check. Making rash and biased decisions with money never ends well. When making decisions with our money, we need to slow down and be deliberate in our decision-making. We need to engage System 2. Behavioral economics provides us with the tools and insights to do just that, but it is up to each of us to act.
As Teddy Roosevelt said, “All the resources we need are in the mind.”
