If you don’t know who you are, Wall Street is an expensive place to find out
Adam Smith, The Money
I read the book The Behavioral Investor by Daniel Crosby a month ago. It is one of the most interesting and relevant books I would have read recently. Primarily, I was fascinated with how each of the details explained in the book ties personally to the behavior patterns I have experienced over my investing journey. I could also correlate with many discussions I have had with peers where similar thought patterns emerged. For someone who always believed in the theory that investing is 10% technical and 90% behavioral, the ideas in the book resonate a lot. You may call it confirmation bias, or subjective validation! But a lot of information can be back-tested and proven correct. The book revolves around 4 psychological aspects that emerge as behavioral risks: Ego Conservatism Attention Emotion.
In the rest of the post, I have simply pasted some key snippets from the book. Each of them provides a fodder for thought. Hence, read slow! and try to pick some perspectives from each of them on human psychological behavior that governs investing decisions.
Equity markets provide an exception to the heuristic that social coherence trumps logic. You were born to
fit in, but investing requires you to stand out. You are wired to protect your ego, but success in markets demands that you subvert it. You are programmed to ask, “Why?”, but must learn to ask, “Why not?” We owe the existence of our cities, churches, founding documents and, yes, even capital markets, to a shared allegiance to the impossible. Thus, trusting in common myths is what makes you human. But learning not to is what will make you a successful investor.
A large body of research suggests that investors profit most when they do the least; The important point is that the evolutionary tendency of the brain toward action – whether caused by overconfidence or some other factor – damages investing returns.
“Irrational primacy effect,” or the tendency to give greater weight to information that comes earlier in a list or sentence. It turns out that what’s true of communication is also true of our lives generally – experiences that we associate with something when we first got to know it, or the state of something when we learned about it, affect how we see it from that point onward. The lessons we learn first are the lessons that last longest.
Your early investing experiences and your recent investment experiences probably loom larger than they ought to and define your subjective experience of what markets look like. The solution is to become a student of market history instead of falling back on your limited lived experience.
Making money feels good, all right; it just doesn’t feel as good as expecting to make money.” If left unchecked, our natural mental processes are a formula for dissatisfaction. We long for wealth but when we get it, the appeal of what we’d so long hoped for quickly dissipates. Psychologists refer to this Sisyphussian struggle as the “hedonic treadmill” and it is what leads us to try, and fail, to keep up with the Joneses.
Thoughts of anticipatory loss, on the contrary, are processed in the anterior insula, a region of the brain that also lights up during periods of physical pain, anxiety, and in reaction to aversive stimuli. In a very real sense, even thinking about financial loss hurts in the most physical sense possible.
We are more in love with ourselves than is warranted, a fact that has dangerous implications for investment decision-making. In an effort to keep this love fest going and preserve precious cognitive processing power, we engage in a three step process: we look for supporting evidence, we congratulate ourselves for believing as we do, and we react violently against attacks to our worldview.
This tendency for beliefs to get even stronger in the face of contradictory evidence, known as the backfire effect, is even more pronounced when the information presented is ambiguous or unclear.
There are a number of psychological variables at play that account for this tendency to prefer the “devil that we know.” One reason is that there is comfort in sameness. People want to know what they are getting into – even if it is boring, bad or unfulfilling. Pain researchers have found that expected pain is much less disruptive than unexpected pain, even if the painful stimulus delivered is of exactly the same intensity. As Kurt Cobain crooned, “I miss the comfort in being sad.”
Your brain is the most metabolically inefficient part of your body and one way that you conserve energy is by going with defaults.
We engage in such fallacious thinking, say Kahneman and Tversky, because “individuals feel stronger regret for bad outcomes that are the consequence of new actions taken than for similar bad consequences resulting from inaction.”
The implications for investing are clear; we tend to overvalue what we own and undervalue unowned alternatives. Even professional traders exhibit a tendency not to sell investments they already hold, even though in many cases they admit that they would not buy the holding in question today if asked to start afresh.
A fallibility in your memory retrieval mechanism is availability heuristic, which simply means that we predict the likelihood of an event based on how easily we can call it to mind rather than how probable it is.
Storytelling bypasses many of the critical filters we apply to other forms of information gathering, which is what makes a movie so immersive to watch but can also give misinformation a superhighway to our mind. For this reason, stories are the enemy of the behavioral investor.
A part of any sensible approach to security selection is determining what matters most and a focus on those variables to the exclusion of the cacophony all around. If everything matters, nothing does.
“Noise makes financial markets possible, but it also makes them imperfect.” No noise, no action. The more noise there is, the more liquidity the market enjoys because assets change hands frequently.
One of the most important rules of behavioral investing is that results matter less than the process; you can be right and still be a moron.
Diversification, truly understood, is not some game whereby we accumulate large numbers of holdings for their own sake, but rather an attempt to insulate ourselves against catastrophic loss.
We must always be able to articulate an edge when we expect prices to deviate sharply from their current state. After all, the price of a security at any given time reflects the consensus estimate of millions and millions of market participants. If we are bold enough to suggest that millions of people will soon be proven wrong, we’d better have a very strong reason for thinking so.
The more difficult the decision we face, the more likely we are not to act.
We imagine that the Mona Lisa is popular because it is so special, but in reality, it is seen as special precisely because it first became popular. The psychological term for this phenomenon is mere exposure effect, a process by which we develop a preference for something simply because we are familiar with it.
Estimated to impact as much as 70% of us, normalcy bias leads us to believe that we have experienced all we can ever experience.
Attitude polarization – Exposing subjects to a balanced set of pro and con considerations actually strengthened their initial position. Sophistication effect – Knowledgeable subjects actually showed a greater tendency to engage in confirmation bias, disconfirmation bias, and prior attitude effect (evaluating supportive arguments more favorably than counter arguments).
Giving in to panic selling or buying glamour stocks of poor quality are done, not because of lack of knowledge, but rather due to lack of restraint
The 12-step addiction literature teaches those in recovery an acronym – H.A.L.T. – that would also serve investors very well. The acronym stands for hungry, angry, lonely, tired and is a reminder to abstain from making important decisions in any of these emotional states.
In capital markets, the right thing to do ceases to be the right thing to do when everyone does it.
Being a behavioral investor means being respectful and aware of bubbles and crashes without becoming paralyzed by that knowledge. The only insanity greater than not insulating yourself against wealth destroying crashes is becoming so fearful of them that you miss out on all of the good that markets do.
Momentum is a financial extrapolation of Newton’s first law of motion: every object in a state of uniform motion tends to remain in that state of motion.
Overconfidence is intuitive enough, but to understand self-attribution, think of being in traffic. If you accidentally cut someone else off during your morning commute, you’re likely to ascribe that behavior to an honest mistake or not being fully caffeinated yet. However, when you are cut off by someone else it’s unlikely that you are so gracious and contextual in your assumptions about their behavior. We tend to ascribe our own successes and blame our failings on externalities, whereas we are quick to ascribe others’ failings to permanent personal characteristics. I cut you off because I haven’t had my coffee, you cut me off because you’re a bad person.
Becoming a behavioral investor is fundamentally about scraping away all of the bad lessons and fallacious visions that you’ve been sold and realizing that doing less gets you more. It is understanding that the less you need to be special, the more special you’ll become. Most of all, it’s about realizing that knowing yourself and building your wealth are parallel pursuits that can only be achieved as you have the personal courage to admit that you’re pretty average, and in so doing, put yourself on the path to becoming so much more.
Looking forward to a bright 2025 and more investing learnings. Cheers!
