Tuesday, August 27, 2013

Biased Brains and Bubble Talk

If you are a human and an investor there is good news and bad news.  The bad news first.  Your brain sucks.  It operates in almost every way possible to encourage you to make bad investing decisions.  It is also why you care a lot more about the Fed’s actions than you really should.

A test will easily demonstrate your faulty brain at work.

  1. Take out a piece of paper.  Write down the last 4 digits of your phone number. (Or say the number out loud like “four thousand three hundred eighty five.”)
  2. Now, do you think the total number of doctors in London is more or less than that number? Think about it for a second and then say out loud “more” or “less.” 
  3. Finally, write down what you think the actual number of doctors in London is.

You know your phone number is completely unrelated to the number of doctors in London, but did it influence your answer?  If you are like most people it certainly did.  The same question was asked to 3,000 portfolio managers in a study done for a book titled, Behavioural Investing.  The average answer for people with a phone number ending in 3,000 or less was 4,000.  The average answer for people with a phone number ending in 7,000 or higher was 8,000.  The average answer was double for those with higher phone numbers. (See end of article for correct answer)

This is an effect referred to as “anchoring.”  It is one of the many biases discussed in behavioral finance literature.  We are constantly influenced or “biased” by how we process information or our emotions and most of the time we do not realize it.  A great book on human behavioral biases in general (not just finance) was written by Nobel Prize winner, Daniel Kahneman.  It is called Thinking, Fast and Slow and I would highly recommend it if you are interested in learning more on the subject.

Back to the Fed and apparent growing asset bubbles in the United States.  Much of this thought can easily be traced to some very influential cognitive biases.  Our brain subconsciously strives for simple answers.  Conflicting information requires a lot of energy to process so we naturally avoid it.  It is called cognitive dissonance.  This concept applies to our understanding the economy and stock market.  In reality we all KNOW that there are a million variables around the world all affecting the U.S. economy and stock market at all times.  We also KNOW that it can’t be as simple as one variable like Fed policy decisions.  But when given the choice to analyze those million variables and make an informed decision on the direction of the economy our lazy brain answers with an emphatic, “No.” 

And for good reason.  Research reveals that no one really knows where the economy will be in 6 months.  But our brain LOVES a simple answer like:  “The Fed is going to raise interest rates; therefore, the stock market will collapse.”  The truth is it is not that simple.  If you think your brain can handle a little “dissonance” here is a great article showing 20 charts that suggest there is a lot more going on than just a Fed driven bubble.

If you have previously held the belief that the U.S. economy hinges on the actions of the Fed then your brain is doing everything it can to discredit this article right now.  But hang in there; this is where the good news comes in.  Having a successful investment plan does not require predicting what the Fed will do or the direction of the economy (your brain should love that statement).  It actually relies solely on creating a portfolio which is based on your personal situation.  A well-diversified, efficient portfolio tailored to your needs is the key.   Making decisions based on what the Fed does next will ultimately end badly for investors.  And that is not just my flawed brain talking.  (Total doctors in London are about 37,000.) 

No comments:

Post a Comment