Investments and investors should be rational, right?
Yet, somehow many of us discover in hindsight that our decisions weren’t as rational or as smart as we thought they were at the time.
In chapter one of “Book of Value: The Fine Art of Investing Wisely,” author Anurag Sharma takes us on a tour of some of the gremlins in our minds, gremlins that keep us from making fully rational decisions.
The first of those gremlins is called “confirmation bias,” a concept uncovered by experimental psychologists. Sometimes we develop or receive an idea that sticks in our minds, perhaps the result of wishful thinking, and it becomes a touchstone. After that, we accept or reject new information according to its alignment with that previous idea.
The second of the gremlins is “belief persistence.” As Sharma noted, for more than a thousand years, the medical community persisted in the belief that bleeding and purging were effective treatments. Many scientists believed that the earth was at the center of the universe, an idea that persisted for more than a millennium and a half. And, need I mention the flat earth?
The third of the gremlins is the “primacy effect,” which refers to the practice of forming opinions quickly based on the information available at that time, and then prejudging all subsequent information according to the initial opinion.
So confirmation bias, the persistence of beliefs and the primacy effect all influence the way we think about investing. According to the author, investors can make mistakes when this psychological baggage interferes with thinking. It doesn’t matter whether one’s beliefs are true or not. “We can easily stretch a little truth to absurd levels, out of all proportion to available evidence,” he wrote.
Sharma went on to argue this is true about both individuals and whole populations, as evidenced by the many investment bubbles that have occurred in the past several hundred years.
And he wound up the chapter by pointing out that investors are human, and thus are subject to these gremlins. Because of confirmation bias, people become too confident in their abilities, whether that’s to drive or invest wisely (ironically, other research shows women do better at investing than men because they are not so overly confident).
I find little to quarrel with in Sharma’s arguments. In fact, I might say, in a loaded phrase, that they confirm what I already believed about the role of mental factors in investments and life.
This chapter also provides a platform for exploring what mental constructs we hold at this time, early March 2020. What do we believe today and are these beliefs tenable?
Let’s start by asking whether behavioral finance is real or just a distraction. If you’re someone who comes to investing by way of academic finance, then you’re likely to think of it as a distraction. As Sharma pointed out previously, academic finance is all about math and data, people and their frailties don’t really count. For example, consider the case of technical analysis, which is based on the belief that everything we need to know about a stock is contained within its prices. All you need to do is to look at those prices on a chart and all will be revealed, in theory, at least.
If you are a value investor, however, you will have a much different perspective. You will believe that anomalies in prices are the result of other investors overreacting to news or some other stimulus. You buy when others are fearful, and you sell when the crowd changes its mind and starts buying back the stock it previously dumped.
What do you believe about the valuation of the market? Both the Shiller price-earnings ratio and Buffett Indicator show the American market is significantly overvalued right now. However, whenever I look at the news, there are many experts telling me the markets have the potential to go much higher. Some even suggest the current dip caused by concern over the coronavirus justifies new investment.
What insights into the market are provided by confirmation bias, belief persistence and the primacy effect? Should we filter everyone’s assessment of the market using these psychological traps, including our own? Perhaps I should say “especially” our own.
If you are a British investor or invest in British companies, you have no doubt been assessing the Brexit situation. Have you asked yourself whether confirmation bias, belief persistence and the primacy effect are influencing your analysis or judgment?
Arguably, the best way to use the information provided by Sharma is for self-examination. For example, I’ve believed for several years that the American market is quite overvalued and, as a result, I’ve been holding some dividend payments in cash. I frequently remind myself of the opportunity cost I’m giving up, but at the same time wonder what I would have to forego if the market drops by 30% or more, as it did in 2008. More self-examination, with particular attention to the three gremlins, might help me resolve that internal tension.
Conclusion
Chapter one of “Book of Value: The Fine Art of Investing Wisely” delves into three inherent issues that often affect our investing decisions: confirmation bias, belief persistence and the primacy effect.
These gremlins lead us to believe things that are not true, and to disbelieve things that are true. In particular, we need to be careful about maintaining old ideas when new evidence makes it clear we should change our thinking.
Finally, I noted that many of us share important ideas about investing and its environment, and asked if we have considered our own thinking about them in light of confirmation bias, belief persistence and the primacy effect.
Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Book of Value: Noise, Luck and Choice
- Book of Value: The Great Divide
- Are There Any Markets That Are Not Overvalued?
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