Behavioral finance rests on a simple premise: The biggest risks in investing are embedded in ourselves as decision makers. Biology encourages our brains to take cognitive shortcuts that can cause big problems.
But psychologist Daniel Crosby believes that we do not have to be our own worst enemies when it comes to investing. “The news is not actually all that bad,” he explained at the Wealth Management 2019 Conference, hosted by CFA Society South Florida. It is possible to navigate around our innate shortcomings and counteract our biases.
“Human nature is both a miracle and a mess,” Crosby said. “Things that have given rise to our success as a species — from a reproductive standpoint, from an evolutionary standpoint — often serve us very poorly as investors.” Risk aversion, for example, has helped us adapt and survive for thousands of years, but it also leads us to make bad financial choices.But the first step to overcoming these errors and making better decisions is identifying those biases that influence our judgment. Academics have already named roughly 200 types of cognitive biases. “Some of these little biases were just to make tenure,” Crosby joked.
We can’t possibly keep track of them all. But the 200 do generally fall into one of several categories. “We are prone to four primary types of behavioral errors,” he said. They are the following:
- Ego: Ego-driven biases manifest as overconfidence, or the belief that we will consistently perform better than average. We believe our insights are more accurate and our measurements more precise than those of others. “Over-precision is one way that we get it wrong,” he said.
- Conservation: These types of bias occur when we stick with what we know, conflating the familiar choice with the best choice. As an example, Crosby highlighted the Mona Lisa — one of the most famous paintings in the world. Do we value the Leonardo da Vinci work based on its artistic merit? Crosby doesn’t believe so. “We confuse having heard of something with something being good, all the time,” he said.
- Attention: These biases allow our memories to influence our assessment of probabilities. As an example, Crosby discussed how memories of the 11 September 2001 terror attacks made many wary of plane travel. This meant more people opted for automobiles for long-distance travel, which in turn led to an increase in traffic fatalities. “We do this all the time, in big ways and small,” he said.
- Emotion: “We confuse our emotions with our risk management,” Crosby said. “We confuse what’s fun and what makes us emotionally feel good with what’s safe.” Emotional behavior has driven booms, busts, and bankruptcies throughout market history.
But recognizing these biases is only the beginning. The next and most critical step is counteracting them. And in this, Occam’s razor applies: The simpler the solution, the better.
“The more complex and dynamic a system, the more simple the solution needs to be,” Crosby said. He recommends checking data carefully, finding ways to develop an outsider’s perspective on subjects with which we aren’t familiar, and taking steps to drain the emotion out of investment decisions. He singled out meditation, in particular, as being especially useful for investment professionals looking to reduce emotional attachment.
Crosby ended his presentation by emphasizing the importance of these ideas for wealth managers serving private clients. “The work you do is important,” he said. “The people you serve are beneficiaries of this good work. But your understanding of them and their behavior sets a ceiling for your effectiveness.”
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