(from Jason Zweig’s 8/24/2018 Wall Street Journal Intelligent Investor column published every Saturday in The Wall Street Journal. Click here for the original post. Jason is also the best- selling author of Your Money and Your Brain. Follow Jason on Twitter @jasonzweigwsj. Write to Jason at firstname.lastname@example.org.)
The findings from the field of behavioral economics apply to everyone. Especially you.
As much as all of us investors wish we were perfectly logical calculating machines, we are human: emotional, distractible, impatient, inconsistent. Behavioral economics is the study of how real human beings—not the walking, talking spreadsheets that traditional economists pretend we are—make financial decisions. Unfortunately, it’s all too easy to persuade yourself that the findings of behavioral economics apply to everyone else but you. After more than 20 years of studying research in that field, here’s how I think most investors interpret it. How many of these sound like you? I know many of them sound like me.
Behavioral economics teaches that people are overconfident: They believe they know more than they do, or they assume their knowledge is more precise than it is.
- I’m 100% certain that’s true for everybody else, but there’s no way that applies to me.
Behavioral economists say that confirmation bias leads most people to seek out evidence supporting what they already believe or to ignore data that might disprove their beliefs.
- That’s so ridiculous I’m not even going to waste my time refuting it.
Behavioral economics says investors are myopic: Short-term losses or costs can blind them to the pursuit of longer-term rewards.
- I could explain all that to you, but I gotta run.
Behavioral economists say you should inform your decisions with the base rate, or the best available historical evidence of how likely an outcome is.
- Why would I do that when my gut feelings give me the right answer, like, pretty much almost all the time?
Extensive research documents unconscious biases, or factors that shape our behavior below the level of awareness.
- Are you kidding me? I’m not aware a single decision of mine that could possibly have been affected by unconscious bias.
Most people tend to be unrealistically optimistic, overestimating how likely they are to have good fortune and underestimating how many bad things will happen to them.
- Ha! Just you wait until Facebook buys my great new scratch-n-sniff app for $10 billion!
The disposition effect leads investors to sell their winning stocks too soon and hold onto their money-losing positions too long.
- Well, I sure don’t suffer from that. I don’t have any losers!
The sunk-cost fallacy leads many people to keep trying to justify a past decision even after it’s become obvious that it was a mistake.
- That’s nonsense, and I’ll prove it to you after I finish checking the price on this stock I bought five years ago. [Pause.] I’ve only lost 85%, so I’ll be back to break-even in no time.
Research in dozens of countries around the world shows that investors almost everywhere keep most of their stock portfolios in shares of local companies instead of spreading their bets worldwide. This “home bias” leaves them underexposed to the benefits of global diversification.
- I’m not surprised people in backward countries would do something dumb like that. I’ve got at least 10% of my assets outside the U.S.!
Research shows that many people are prone to “status-quo bias” or investing inertia, preferring to leave their current portfolio in place even when they might be better off switching to other choices.
- But all my investments are already perfect. Why would I want to change?
Behavioral economics shows that people are predictably bad at estimating probabilities: They tend to overestimate the likelihood of rare events and underestimate the frequency of common events.
- Well, sure, but haven’t these scientists ever noticed somebody wins Powerball almost every week? The jackpot’s up to $459 million, so excuse me while I go buy 25 tickets.
Many people exhibit what’s called the bias blind spot, or the tendency to see clearly that other people’s behavior isn’t optimal while remaining oblivious to our own shortcomings.
- The more I think about it, the more I can see how that might apply to people like you.
Experiments in behavioral economics show that most people are prone to anchoring. People who compare prices to the last digits of their Social Security number, for instance, are willing to pay more for something if their final digits are high.
- People are so irrational! Hey, can you believe this guy on CNBC? He just said Apple stock’s going to $300 a share. There’s no way it’s worth more than, like, $285.
Experiments have shown for decades that people tend to draw sweeping conclusions from extremely small samples of data.
- Without even thinking about it, I can come up with three people who would never do that: me, myself and I.
- That’s nonsen—WHAT DO YOU MEAN, THE DOW IS DOWN 140 POINTS?