Medicine used to be all about biology. Fifty years ago it began incorporating elements of psychology into the med school curriculum. It was a breakthrough. Diseases are risks. Treatments have risks. If you’re in the business of treating risks with risky solutions, you can’t scratch the surface until you know the crazy, counterintuitive ways people think about risk.
Finance and economics have evolved the same way. The financial crisis – when people did things no traditional economics textbook could explain – put a spotlight on behavioral finance’s usefulness. Daniel Kahneman is probably the most famous living economist. And he’s a psychologist.
Behavioral finance for most of us is the study of little mind tricks we play on ourselves. Everyone knows the big ones: confirmation bias, overconfidence, anchoring. But there are dozens of other examples of people playing themselves.
A few of the lesser-known ones I find fascinating:
Assuming you think differently than your peers, even if you actually think just like everyone else.
The best example is when a teacher asks “any questions?” and no one raises their hand after a lecture where no student understands anything that was taught. No one wants to look like the only person who doesn’t get it, so no one admits not getting it even when no one gets it.
Another version of this is when everyone thinks they’re a contrarian. The heart of pluralistic ignorance is having misperceptions about how others in your peer group think. And that’s usually what happens when you have a view about an investment that you assume isn’t held by a large percentage of other investors. Take the Berkshire Hathaway annual meeting, which is coming up next week. It’s 40,000 people, all of whom consider themselves contrarians. People show up at 4 am to wait in line with thousands of other people to tell each other about their lifelong commitment to not following the crowd. Pluralistic ignorance at its finest.
Assuming two things are correlated because that correlation seems common sense, even though there’s actually no relationship. Then you only notice times when those two things coincidentally appear next to each other, ignoring all the times they don’t, leading you to believe that the correlation not only exists but is strong.
There is virtually no correlation between annual changes in GDP growth and market returns. Same with top tax rates and GDP growth. But every fiber in your being might tell you that there should be a correlation. So you’ll pay attention to the two variables when they happen to coincide, ignoring all the rest.
This is also true for things like money and happiness, where a correlation exists but is much smaller than most people assume. That’s easy to ignore, because rich people post pictures on Instagram of their private jets, which looks fun and you can pay attention to, not arguing with their spouse or being sued by a neighbor, which isn’t fun and you don’t see.
Rosy prospection and retrospection
Anticipating that something in the future is going to be better than it actually will be, and remembering that event as being better than it actually was. Basically you love all states of time except the present, which never feels better than “just OK.”
It’s caused by a few things. One is that when we anticipate future events we think of them in isolation, without the associated baggage and nonsense that accompanies real life. Say you anticipate a beach vacation. Imagining yourself laying on the beach in the sun sounds nice. Then you get to the beach and all the umbrellas are taken, you get sunscreen in your eyes, and you step on a piece of coral. After you get home you remember the trip as being wonderful. Why? Partly because the sunscreen is now out of your eyes, and partly because you spent $10,000 on a beach vacation and it hurts to remember it as anything but nice.
This is so powerful in investing. “The easy money has already been made” is only said by people who can’t remember how hard and uncertain it was to make money in the past. And those who think investing will be easy if you just have a long-term mindset ignore that the long run is just a collection of short runs, each of which has uncertainty, volatility, and decisions that have to be dealt with. The difference between a long-term chart that you get to enjoy and the zoomed-in section of that chart that you have to live is the rosy prospection and retrospection bias.
Leveling and sharpening effects
Memories of certain parts of an event are retold and sharpened in your mind because they make sense to you, while other parts of an event are kept out because they don’t fit one of your existing mental models, leveling their importance. So memory of big events can become distorted over time, giving more weight to some details – particularly the parts that make good, easy stories – while other details become forgotten and filled in with bits of the sharpened memory. The sharpened memories can take on a life of their own, morphing into false memories as the whole story has to be contorted to make up for the gaps created by the leveled memories.
Take the financial crisis. A lot of stuff happened, but you can’t remember it all. You select the parts that make the most sense to you, replay them in your head, and tend to forget the rest. Say it’s easy for you to recall that the Federal Reserve expanded its balance sheet by a few trillion dollars. So you replay that memory constantly. And say you have an idea in your head that this should have sparked hyperinflation. Leveling and sharpening increase the odds that over time you’ll remember the financial crisis as being accompanied by hyperinflation. The fact that prices actually fell will become a leveled memory, swept away by the mental model of what you think should have happened.
Thinking the outcome of a decision you made is better than it actually was, and downplaying the performance of the option you decided against. A cousin of this is misremembering how and why you did something in a way that justifies your past decisions.
A fund manager I worked with at a previous job once reflexively told me he’s outperformed the market. We were at a computer, so we checked. Turns out he had not. “Well, I’m hedged” was his reply. A choice-supportive error on display.
Another version of this is a false narrative about why you made an investment. Say you think the Amazon Fire phone is going to be the next trillion-dollar business. So you buy Amazon stock. Then Amazon stock explodes higher because of Prime, AWS, and its core retail business. Nine times out of ten you will forget your initial thesis and remember your reason for making the investment being the same reason that made the investment perform well. The same thing works in reverse.
The most important part of this post is realizing that all of these things apply to you, not just other people.