How to Beat Our Investing Biases
Admitting to our prejudices as investors is the first step to overcoming them.
The notion that we're hard-wired to make poor decisions is a central tenet of investor psychology. Of course, some of us are wired better than others. Warren Buffett, for example, seems to have emerged from the womb ready to go, like the Aztec god Huitzilopochtli. But instead of springing to life fully grown and armed to the teeth, Buffett, from an early age, worked, saved and obsessively counted stuff (including golf balls he'd steal from the local Sears).
The question is, how much of our investing behavior is predetermined? Can we change our behavior? And, if so, how? The answer to the first question: about one-third. A recent study, "Nature or Nurture: What Determines Investor Behavior," examined the investing habits of identical and fraternal twins. It showed that genetics accounted for one-third of such key measures as how willing we are to invest in the stock market and how we allocate our funds. Upbringing had some influence on how the subjects handled money, the study also showed, but experiences with money outside the family quickly trumped parental influences.
So, although nature and nurture are both significant, they don't necessarily control our destiny as investors. What's more important is to recognize that it's human nature to fall prey to our biases, which include overconfidence, short-term thinking and inertia. Problem is, we have a blind spot when it comes to these biases -- we usually don't recognize them in ourselves. And until we do, we can't address them. That makes blind-spot bias the mother of all psychological investing problems.
Emily Pronin, a professor of psychology at Princeton University, says we fall victim to BSB even when we're shown incontrovertible evidence that it exists. "I spend a whole lecture describing blind-spot bias, and I give my students lots of examples of biases," says Pronin -- say, believing you're smarter than the average person, or more altruistic than others or more socially desirable than average. A few days later, she says, a graduate student from another class asks the same students how much they show bias relative to others in the class. "And they still tend to say they're free from the bias," says Pronin.
Pronin says people deny that they suffer from these issues because they occur subconsciously. "In order to determine whether they are biased," she writes, "people generally look to their conscious motives rather than to their actions." So when a bias occurs subconsciously, people don't notice it.
To liberate us from BSB, Pronin came up with a simple solution: She had students read an article, titled "Unaware of Our Unawareness," that convincingly lays out the case that our subconscious can influence our attitudes and behavior. After reading the article, one group didn't show the usual tendency to deny their biases. Those who skipped the article did. Read it yourself [Link]here[/Link]. (Note that Pronin created the article as an educational tool for her students; it is not an actual published report.)
Once you admit to your investing biases, you can begin to overcome them. But don't expect to rewire yourself. "You can improve, you can become more self-aware, but you can't change who you are in a meaningful way," says Frank Murtha, a behavioral-finance consultant with MarketPsych, which offers psychological-training services to traders and money managers.
Becoming more self-aware involves several steps. Among other things, Murtha and his Market-Psych partner, Richard Peterson, have developed a quiz to help you figure out when you're acting impulsively regarding your investments and when you're being consistent. Their book, MarketPsych: How to Manage Fear and Build Your Investor Identity (Wiley, $40), is the best book, in my opinion, for helping you learn to identify and control your biases. Plus, it's a fun read.
Kiplinger's is partnering with Nightly Business Report on the "Your Mind & Your Money" series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Sept. 13 and 27.