Why does emotion so often outweigh logic in decision making? Our unconscious mind is a major culprit: It filters out unpleasant information as it is received to reduce the sheer volume of data coming in, according to Richard Taffler and David Tuckett’s research. That means our conscious mind does not always receive all the pertinent information it needs to make the best decision.
This leads us to ignore the warning signs and turn to the familiarity bias of behavioral finance that Kirsty Best described. What is familiarity bias? When we trend toward investing in things we understand, or think we understand. Best’s investigation into this phenomenon focused on the internet stock mania that spread like wildfire in the late 1990s before burning itself out in 2000. Best compared internet stocks with celebrity sightings.
Everyone wanted to be part of this cool new offering, even when logic told them that every new company couldn’t possibly take off the way Yahoo!, eBay, Amazon, and Google had. But as stock prices soared and more and more people learned of the internet and its massive potential, they put more and more money into these startups, regardless of whether they had done any research into whether they would succeed or fail.
The media helped inflate this bubble and facilitated its subsequent burst by assigning cultural status to internet stocks and promoting investing as a lifestyle. People who had no real knowledge of what financial investing is all about were sucked in.
Confirmation Bias and Denial
If we believe one candidate will make the ideal president, we’ll follow their campaign very closely, tune in when they are interviewed, and listen up when they tweet or release a new commercial. And when the talking heads on the news or our friends and family blast them for their voting record or offer any other kind of criticism, we’ll tune them out.
This is the heart of confirmation bias: We prioritize information that supports the opinion we already have. If mutual funds are the reason why our parents were able to retire at 55, we’ll naturally have a higher opinion of these securities. Thus, when we see a special report on how mutual funds are failing to reap the dividends of 30 years ago, we’ll tend to ignore that data as irrelevant given the personal success we’ve witnessed firsthand.
Let’s face it, investors tend to have healthy egos when it comes to their stock-picking abilities. This is often heightened by a gambler’s mindset: We remember our biggest scores, but selectively forget the losses we pile up in between our jackpots.
When we’re overconfident, we explain away our mistakes or losses. We see them as flukes or someone else’s fault. Big gains, on the other hand, are solely the result of our own expertise. This can lead to unwarranted, overexaggerated investing, as Brad M. Barber and Terrance Odean demonstrate. Overconfident investors will risk far more money on a venture than their less confident counterparts.
Herding can be just as dangerous as overconfidence, often making us behave like cattle, moving in packs that are easily spooked into a stampede. At the root of herding is the concept of social influence. This is when large groups respond in the same way based on an outside factor, whether it’s new information, words from a perceived leader, or observed behavior by someone the herd identifies with.
Social influences are the roots of bubbles and crashes regardless of the market they exist in, as Vernon L. Smith explained. For instance, bubbles tend to occur in markets where we have no defined opinion or previous experience to draw upon. Thus, startup industries often balloon and then deflate as we “chase” our neighbors without realizing that no one really knows where they are going. Indeed, David Hirshleifer found that we may follow others for no real reason.
So, how do we get better at decision making? There are some practical tips that can help us detach our emotions from our decision-making process and lead us to more rational choices. I will explore those in the final edition of this series.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/erhui1979
Continuing Education for CFA Institute Members
Select articles are eligible for continuing education (CE) credit. Record credits easily using the CFA Institute Members App, available on iOS and Android.