Behavioral bias exists – using financial theory to inform, data to validate and learn, and technology and design to implement, can help us make the best out of behavioral biases
- Don’t be fooled by randomness
- Human beings are predictability irrational
- Understand the difference between thinking fast and slow
While not exactly famous for his insights in behavioral economics, J.P. Morgan had observed when making decisions “there are the right reasons and then there are the real reasons”. Understanding the real reasons can open up a completely different way of approaching investment decisions.
Our behavioral biases cause us to make decisions either individually or collectively that be appear irrational from a true economic sense. Individuals and businesses consciously or unconsciously make decisions or are swayed by their emotional state, or by non-economic factors when making decisions.
We tend to place a lot of faith on our intuition, yet our intuition is informed by our immediate surroundings and memories … And in certain cases that may lead us to make incorrect conclusions.
We tend to confuse randomness with skill, especially when it comes to our own decisions. We may pat ourselves on the back for having bought Apple stock, or having picked the right time to sell our equity portfolio – however, some of the major factors that drive outcomes are based on luck, or randomness. Larry Page and Sergey Brin are brilliant and skilled, but they were also lucky that Excite declined to buy Google for less than one million dollars in 1999.
There is nothing wrong with being lucky – however, if we can recognize the role that randomness plays in generating performance, we might be able to channel it better in our decision making.
We might be able to improve our manager selection process to identify those managers with systematic, repeatable processes vs. those who might have been lucky with their market timing call over the last three years. We might still choose to keep the lucky ones as option value – what is important is that we recognize the role that luck plays, and how to maximize value once we get lucky.
We can control our impulses to make irrational investment decisions and can take advantage of behavioral biases of other market participants. We can recognize behavioral biases inherent in the decisions that investment committees make. Kahneman, Ariely, Taleb and others have provided the basic perspective and insights. And tech and finance have provided us with the tools.
The solutions don’t need to be complex. For example, creating a basic checklist can help us overcome biases and improve effectiveness. In the Checklist Manifesto, Atul Gawande brilliantly illustrates how simple checklists can save lives.
In further articles I shall elaborate some thoughts on how we can bring all of this together to improve how we make investment decisions.