These biases make it harder to reach your financial goals

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Bob Pisani’s book Shut Up & Keep Talking

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(Below is an excerpt from Bob Pisani’s new book, Shut Up and Keep Talking: Lessons on Life and Investing from the Floor of the New York Stock Exchange.)

Most people like to think they are rational. But — at least when it comes to investing — that’s not always the case.

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As early as 1979, Daniel Kahneman and Amos Tversky established that people do not act in the way that classical economics dictates.

They were not necessarily rational actors. For example, they didn’t buy low and sell high. They often did the opposite.

Why? Kahneman and Tversky proposed a theory they called prospect theory. Her key finding was that individuals don’t experience gains and losses in the same way. According to classic theories, the joy someone feels from winning $1,000 should equal the pain they would feel from losing $1,000.

Kahneman and Tversky didn’t figure that out. They found that the pain of loss is greater than the joy of gain. This effect, known as loss aversion, has become one of the cornerstones of behavioral economics.

In later years, Kahneman and Tversky even attempted to quantify how much more severe the loss was. They found that fear of emotional loss was more than twice as strong as emotional gain.

That went a long way toward explaining why so many people hold onto losing positions for so long. The opposite is also true: people will tend to sell their winners to make a profit.

You have more prejudices than you think

Over the years, Kahneman and many others have described numerous biases and mental shortcuts (heuristics) that humans have developed to make decisions.

Many of these biases are now an integral part of our understanding of how people interact with the stock market.

These biases can be divided into two groups: cognitive biases stemming from mistakes in reasoning and emotional biases stemming from feelings. Loss aversion is an example of an emotional bias.

They can be very difficult to overcome because they are based on feelings that are deeply ingrained in the brain. See if you recognize yourself in any of these emotional biases.

Investors become:

Come to believe that you are infallible when you are on a winning streak (overconfidence).

Blindly follow what others are doing (herd behavior).

Value something you already own above its true market value (endowment effect).

Refrain from planning long term goals like retirement as it is easier to plan short term goals like a vacation (self control).

Avoid making decisions out of fear that the decision might be wrong (regret bias).

There are also cognitive errors

Cognitive errors are different. They don’t come from emotional reactions, but from mistakes in reasoning. They happen because most people have a poor understanding of probabilities and how to give numerical values ​​to those probabilities.

people become:

Come to the conclusion. Daniel Kahneman said in his seminal 2011 book, Thinking, Fast and Slow, “Jump jumping to conclusions based on limited evidence is so important to understanding intuitive thinking, and it comes up so often in this book, that I’ll go for it use a cumbersome abbreviation: WYSIATI, which stands for what you see is all there is.”

Select information that supports one’s point of view and ignore information that contradicts it (confirmation bias).

Give more weight to newer information than older information (recency bias).

Convincing themselves that they understood or predicted an event after it happened, leading to overconfidence in the ability to predict future events (hindsight bias).

Respond differently to financial news depending on how it’s presented. They can react differently to the same investment opportunity or to a financial headline depending on whether it is perceived positively or negatively (framing bias).

Believe that a stock that has performed well in the past will continue to do well in the future (gambler’s fallacy).

Overreacting to certain messages and not putting the information in the right context, making that message seem more valid or important than it really is (availability bias).

Rely too much on a single piece of information (often the first) as a basis for an investment (e.g. a stock price), which becomes the reference point for future decisions without considering other information (anchoring bias).

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People have so many prejudices that it is difficult to make rational decisions.

Here are some key takeaways:

It is possible to train people to think more rationally about investing, but don’t expect too much. With all these brilliant insights into how people really think (or don’t think), you’d think that as investors we wouldn’t repeat the same stupid mistakes we’ve been making for thousands of years.

Unfortunately, investing in wisdom and insight remains in short supply because 1) financial illiteracy is rampant. Most people (and sadly, most investors) have no idea who Daniel Kahneman is, and 2) even people who know better continue to make silly mistakes because they shut down the brain’s “react first, think later” system Empowering Daniel Kahneman in “Thinking, Fast and Slow” is really, really hard.

The indexing crowd got a boost from behavioral economics. Billions of dollars have poured into passive (index-based) investing strategies over the past 20 years (and especially since the Great Financial Crisis), and for good reason: unless you want to endlessly analyze yourself and everyone around you, passive investing made sense because it many of the prejudices described above are reduced or eliminated. Of course, some of these passive investments may have their own biases.

Stocks can be mispriced. Psychology plays a big part in setting at least short-term stock prices. It is now accepted that markets may not be perfectly efficient and that irrational decisions by investors can have at least short-term effects on stock prices. In particular, stock market bubbles and panics are now largely viewed through the lens of behavioral finance.

Behavioral economics wins the Nobel Prize

At least the whole world recognizes the contributions that behavioral economists have made.

Daniel Kahneman received the 2002 Nobel Memorial Prize in Economics for his work on prospect theory, specifically for “the integration of insights from psychological research into economics, particularly as they relate to human judgment and decision-making under uncertainty”.

Other Nobel prizes for work in behavioral economics soon followed. Richard Thaler, who teaches at the University of Chicago Booth School of Business, received the 2017 Nobel Memorial Prize in Economics. Thaler, too, had shown that humans act irrationally, but they did so in predictable ways, which raised hopes of some form of model might yet be developed to understand human behavior.

Yale Professor Robert Shiller received the 2013 Nobel Memorial Prize in Economics (with Eugene Fama and Lars Peter Hansen) for his contribution to our understanding of how human behavior affects stock prices.

Bob Pisani is senior market correspondent for CNBC. He has spent nearly three decades reporting from the floor of the New York Stock Exchange. In Shut Up and Keep Talking, Pisani shares stories about what he’s learned about life and investing.