The 2017 Nobel economics prize has been awarded to Richard Thaler of the University of Chicago for research on behavioral economics, which shows how our emotions can impact economic decision-making, as well as our investment performance. Thaler’s body of work has built on that of Israeli psychologists Daniel Kahneman and Amos Tversky, who forty years ago showed the ways in which the human mind systematically erred, when forced to make judgments in uncertain situations.
Behavioral economics can be helpful in explaining why so many of us become our own worst enemies when it comes to investing. The problem is simple: human beings are not always rational. The Nobel committee said Thaler’s work has painted a “more realistic analysis of how people think and behave when making economic decisions…by exploring the consequences of limited rationality, social preferences, and lack of self-control.” Here are four ways our emotions can betray us:
1) Confirmation Bias: Who doesn’t want confirmation that we are “correct”? From politics, to restaurants to investing, we seek out experts and information that confirms our beliefs. So if you believe that the stock market is likely to keep rising or conversely, that a crash is imminent, you are likely to find affirmation of those views as a rationale for continuing to hold them. The best way to fight confirmation bias is to find credible sources that argue the other side and to resist any urge to outguess the trend by sticking to a diversified portfolio, which you rebalance on a periodic basis.
2) Recency Bias: The tendency to remember recent events more vividly and give recent information more weight than historical information, can cause us to believe that what’s happened recently will continue to occur. Investors are constantly influenced by this bias: When stocks are trading higher, they erroneously believe that the trend will persist and when they tumble, they cash out and hide, thinking that stocks will hurtle towards zero. Recency bias is the reason that securities law requires that every investment disclosure contain this sentence: "Past performance is no guarantee of future results." While many gloss over the warning, they do so at their own peril—these investors may chase performance, ultimately causing them to underperform the very indexes into which they have poured their money. When markets are reaching new highs or lows, fight this bias by returning to the reasons that you are investing and remind yourself that there is no reason to alter your plan.
3) Mental accounting: Thaler identified this bias, after finding “people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect.” For example, we treat employment income differently than money from a windfall, like an inheritance. Or when someone holds an outsized proportion of her portfolio in a specific stock—maybe because of a legacy with that company or because it has been a strong performer, she can get emotionally tied to it and make bad decisions about its disposition. Investors can manage mental accounting by limiting any individual stock position to 5 percent of their total portfolio.
4) Illusion of control bias: Some investors want to believe that with time, energy and focus, they—or some other expert, can determine which assets will outperform others and therefore, they can control investment outcomes. Sadly, Mr. Market consistently proves them wrong. It is difficult for many to face the fact that the market can be irrational, unpredictable and volatile in the short term. The best way to combat that fact is to accept it and create a plan that accounts for variability.