Modern financial theory is based upon the concept of efficient markets: the idea that investors are rational and that they accurately process all available information to inform investment decisions, at least in the aggregate. This is a useful generalization that makes possible the quantitative analytical framework underlying modern finance.
Problem is, it just ain't so.
It does turn out that large, liquid markets are reasonably efficient over very long periods of time. But we have long recognized that individuals display a plethora of biases impelling them to make sub-optimal investment decisions that can significantly retard their returns over time. Learning to identify these all-too-human tendencies is an important step in overcoming them.
Actually, many of the emotional and psychological responses that impede our investing process are responsible for ensuring the perpetuation of our species. Confronted with the roar of a man-eating tiger, our ancestors did not have the luxury of collecting additional data for later analysis but instead hightailed it back to the safety of the cave. This set of hard-wired mental circuits that kept us alive in earlier eras now conspire against us when applied to long-term processes like investing that require rational analysis and patience.
Furthermore, the human brain, although a remarkably complex organ, is limited in its ability to process large amounts of information and therefore adopts critical shortcuts in order to contend with complex situations. We routinely employ heuristics or rules of thumb to simplify otherwise impossibly complicated decisions as a basic survival mechanism. This is an indispensable response to the myriad sensory inputs bombarding our mental receivers every second, but is a return killer when it impacts our stock picks.
These critical innate behavioral characteristics present challenges in making rational financial decisions. They show up in a number of increasingly well understood cognitive biases that take their toll on investment performance.
' Loss aversion. This nearly universal trait distorts the relative value of gains and losses, leading to poor decision making. Investors view the value of a dollar differently depending on whether that dollar was won or lost. Researchers have shown that on average, people weigh losses about twice as heavily as gains of equal amount. This is the antithesis of the "rational" investor assumption of modern finance.
' Herding. Even the lowly wildebeest knows there is safety in numbers. Human investors tend to display the same behavior in managing portfolios, piling into stocks that are widely owned and eschewing unloved names. Contrarianism, or going against the grain, is more profitable but harder to accomplish.
' Optimism bias. Otherwise known as overconfidence, this is the tendency to overestimate our abilities. Think of the mythical home of Garrison Keillor, where all the children are above average. The optimism bias often leads to excessive trading, which is virtually always associated with underperformance.
' Gambler's fallacy. This is the common but erroneous belief in streaks, runs of luck and hot hands. Investors frequently fall victim to the notion that they are "due" for a reversal of fortune. A common example of the gambler's fallacy is the mistaken belief that 20 consecutive coin tosses that come up heads make a tail more likely on the 21st toss.
It requires discipline to overcome these instinctive impediments to a patient and consistent investment process, but recognizing them is the first step. Systematic investment plans like dollar cost averaging without regard to the level of the market can help subdue urges to time the market. And periodic rebalancing of your portfolio to a target asset allocation is a great way to maintain discipline and subdue the primal urge to panic.
Still, if you hear a tiger, run.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.