Think You're a Good Investor? Science Says You're Not (but If You Avoid 2 Cognitive Biases, You Could Be)
Research reveals that what you say drives your investment decisions isn't actually the reason. (Which might explain why the average investor rarely outperforms the market
Even though it's mathematically impossible, research shows that if you provide people with a survey about almost any trait, the vast majority will rate themselves as above average. (For example, nearly everyone considers themselves to be an above-average driver.)
Take investing. While I know I'm no Warren Buffett, I do think I make thoughtful, rational, data-driven investment decisions.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
That's why the vast majority of investors aren't always rational. Few of us beat the market. Above average? Nope. We aren't even "average."
But we don't have to be.
For example, take another cognitive bias: loss avoidance. Most of us tend to strongly prefer to avoid a loss than to acquire a gain. We're much more likely to want to avoid losing $100 than to make $100.
In fact, research by Daniel Kahneman, author of the great book Thinking, Fast and Slow, indicates that losses are twice as psychologically powerful as gains. (Yep: A bird in the hand really is worth two in the bush.)
That bias is understandable. A loss means giving up something I actually have. Not acquiring a gain means giving up something theoretical rather than actual: If I have a chance to make $100 but don't, that sucks, but if I have $100 and lose it, that really sucks.
The problem with loss avoidance is that it typically defaults to the status quo. In broader terms, say you decide not to attend a networking event because you don't want to give up an hour of your time. Fine -- but what if you might have met the perfect partner for a joint venture? Or say you decide you don't want to invest $20,000 in your business because you hate the thought of losing it. Fine -- but what if you might have created a product line that would open up a great new revenue stream?
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
That's why the vast majority of investors aren't always rational. Few of us beat the market. Above average? Nope. We aren't even "average."
But we don't have to be.
For example, take another cognitive bias: loss avoidance. Most of us tend to strongly prefer to avoid a loss than to acquire a gain. We're much more likely to want to avoid losing $100 than to make $100.
In fact, research by Daniel Kahneman, author of the great book Thinking, Fast and Slow, indicates that losses are twice as psychologically powerful as gains. (Yep: A bird in the hand really is worth two in the bush.)
That bias is understandable. A loss means giving up something I actually have. Not acquiring a gain means giving up something theoretical rather than actual: If I have a chance to make $100 but don't, that sucks, but if I have $100 and lose it, that really sucks.
The problem with loss avoidance is that it typically defaults to the status quo. In broader terms, say you decide not to attend a networking event because you don't want to give up an hour of your time. Fine -- but what if you might have met the perfect partner for a joint venture? Or say you decide you don't want to invest $20,000 in your business because you hate the thought of losing it. Fine -- but what if you might have created a product line that would open up a great new revenue stream?
To generate a return, you can't stay status quo; you have to do something. The key is to properly value the potential loss, and put safeguards in place to limit your loss if the investment goes south. (A stop-loss order would have saved me a bundle when my Blue Apron stock tanked.)
In broader terms, always take a step back and consider why you're making a certain decision. Chances are your initial motive is based on a cognitive bias or two. Instead of falling prey to "myside" bias -- forming a hypothesis and then seeking data that supports your hypothesis -- seek data first.
Then draw conclusions from that data.
That way you're a lot less likely to be biased, and more likely to make smarter investments based on what you know.
Especially about how you make decisions.
Even though it's mathematically impossible, research shows that if you provide people with a survey about almost any trait, the vast majority will rate themselves as above average. (For example, nearly everyone considers themselves to be an above-average driver.)
Take investing. While I know I'm no Warren Buffett, I do think I make thoughtful, rational, data-driven investment decisions.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
That's why the vast majority of investors aren't always rational. Few of us beat the market. Above average? Nope. We aren't even "average."
But we don't have to be.
For example, take another cognitive bias: loss avoidance. Most of us tend to strongly prefer to avoid a loss than to acquire a gain. We're much more likely to want to avoid losing $100 than to make $100.
In fact, research by Daniel Kahneman, author of the great book Thinking, Fast and Slow, indicates that losses are twice as psychologically powerful as gains. (Yep: A bird in the hand really is worth two in the bush.)
That bias is understandable. A loss means giving up something I actually have. Not acquiring a gain means giving up something theoretical rather than actual: If I have a chance to make $100 but don't, that sucks, but if I have $100 and lose it, that really sucks.
The problem with loss avoidance is that it typically defaults to the status quo. In broader terms, say you decide not to attend a networking event because you don't want to give up an hour of your time. Fine -- but what if you might have met the perfect partner for a joint venture? Or say you decide you don't want to invest $20,000 in your business because you hate the thought of losing it. Fine -- but what if you might have created a product line that would open up a great new revenue stream?
But that's probably not the case.
A working paper published earlier this year in National Bureau of Economic Research shows that the reasons "retail investors" (meaning people like us) give for making certain investment decisions don't match their actual behavior.
Like when I bought Blue Apron stock a few years ago. For a while, I was up on paper. Then the share price tumbled. Finally -- way too late -- I got out. I was bummed. I felt really stupid.
So I made other investments. A few made a little money. Others didn't. I bounced around a fair bit, searching for that one killer trade to earn back what I had lost.
(That behavior didn't make me above average. It made me decidedly average: Research also shows that retail investors perform poorly relative to the market index, and those who trade more often typically perform even worse.)
If asked, I would have said I was trying to balance volatility with return. I would have said I was using past performance to predict future performance. I would have said I was using information to estimate potential returns.
But what I was really doing was what the authors of the NBER study found were the two factors that drove most investors' decisions: hoping to generate a huge win, and assuming I knew something that the broader market did not. (Granted, that bias is inherent in almost every investor's decision-making: If we all know the same things, we'll all achieve the same results.)
That made me just like everyone else. To paraphrase the researchers, even though gambling preference -- a cognitive bias where we tend to aim for big wins -- and perceived information advantage have substantial explanatory power, most respondents pointed to other factors that supported their investment decisions.
Or, in simple terms, why I say I do certain things isn't actually why I do certain things. (Hi, cognitive biases!)
Why? Because we're people. To borrow the title of Dan Ariely's book, we're predictably irrational. That's why consumers aren't always rational. That's why markets aren't always rational.
That's why the vast majority of investors aren't always rational. Few of us beat the market. Above average? Nope. We aren't even "average."
But we don't have to be.
For example, take another cognitive bias: loss avoidance. Most of us tend to strongly prefer to avoid a loss than to acquire a gain. We're much more likely to want to avoid losing $100 than to make $100.
In fact, research by Daniel Kahneman, author of the great book Thinking, Fast and Slow, indicates that losses are twice as psychologically powerful as gains. (Yep: A bird in the hand really is worth two in the bush.)
That bias is understandable. A loss means giving up something I actually have. Not acquiring a gain means giving up something theoretical rather than actual: If I have a chance to make $100 but don't, that sucks, but if I have $100 and lose it, that really sucks.
The problem with loss avoidance is that it typically defaults to the status quo. In broader terms, say you decide not to attend a networking event because you don't want to give up an hour of your time. Fine -- but what if you might have met the perfect partner for a joint venture? Or say you decide you don't want to invest $20,000 in your business because you hate the thought of losing it. Fine -- but what if you might have created a product line that would open up a great new revenue stream?
To generate a return, you can't stay status quo; you have to do something. The key is to properly value the potential loss, and put safeguards in place to limit your loss if the investment goes south. (A stop-loss order would have saved me a bundle when my Blue Apron stock tanked.)
In broader terms, always take a step back and consider why you're making a certain decision. Chances are your initial motive is based on a cognitive bias or two. Instead of falling prey to "myside" bias -- forming a hypothesis and then seeking data that supports your hypothesis -- seek data first.
Then draw conclusions from that data.
That way you're a lot less likely to be biased, and more likely to make smarter investments based on what you know.
Especially about how you make decisions.
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