Apprenticed Investor: Know Thyself

Apprenticed Investor: Know Thyself
Barry Ritholtz
05/03/05 – 10:20 AM EDT

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Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it’s not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.

The problem, it seems, is a design flaw.

Indeed, many classic investor errors — overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up — are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.

Why is that? The problems lay primarily in our large mammalian brains. It is actually better at some things than you may realize, but (unfortunately) much worse at many others you are unaware of. Most people are unaware they even have these (for lack of a better word) “defects.” The fact is, when it comes to investing, humans just ain’t built for it.

Psychology Vs. Economics

In order to understand how humans invest requires more than the study of economics; one also needs to comprehend behavioral psychology. Combining both cognitive science and behavioral economics can yield powerful insights into the conduct of investors.

I recommend Cornell professor Thomas Gilovich’s book How We Know What Isn’t So to investors all the time. The professor’s contribution to the investment community is his study of human reasoning errors. More specifically, Gilovich studies the inherent biases and faulty thinking endemic to all us humans. These faulty analyses are pretty much hard-wired into our species.

How do these defects manifest themselves? In all too many ways: Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.

We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate “systematic errors” or blind spots in our analytical reasoning.

And that’s only a partial list of analytical imperfections you have inherited.

The good news: These defects can be overcome.

We can develop an awareness of these specific defects, and we can learn to employ strategies that attempt to overcome these inherent analytical shortcomings.

What Have You Learned in the Past 2 Seconds?

Let’s place these defects into a historical framework within the context of the capital markets. My favorite illustration as to why humans simply aren’t hard-wired to undertake risk/reward analysis in capital markets comes from Michael Mauboussin, Legg Mason Funds’ chief investment strategist.

Mauboussin takes our evolutionary argument — the mind is better suited for hunting and gathering than it is for understanding Bayesian analysis — and places it into a chronological context. In an article titled What Have You Learned in the Past 2 Seconds?, he creates a timeline of human history scaled to equal one day.

He starts at the beginning: Homo Sapiens came into existence 2 million years ago. Next, Mitochondrial Eve, the common female ancestor among all living humans, lived less than 200,000 years ago. Last, he notes that modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago. If all of human history were a day long, then investing is only about two seconds old. Is it any surprise that most humans do it so poorly? The vast majority of human history has been spent learning to survive, not analyze P/E ratios.

Learning to fight nature won’t be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you’ll have to overcome your ego’s predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).

Most investors are overconfident to a fault. Don’t believe me? Consider the following anecdote: A man was terrified to fly, yet thought nothing of roaring down the street — sans helmet, no less — on his Harley. That reveals a high degree of confidence in his own skills vs. a highly trained pilot’s. That’s some risk-analysis engine you got there, bub.

That blind faith in our own abilities may have come in handy on mammoth hunts, but it is hardly beneficial when to comes to picking stocks. And that’s before we even get to the “flight or fight” response. Our natural instinct during periods of volatility is to stop the pain, not to endure it with patience. The natural reactions to discomfort or threat — coupled with a natural inability to be patient — doesn’t serve us well in the market. During market bottoms, most of the herd is selling. To buy during periods of intense selling means leaving the safety of the crowd, standing out, risking humiliation.

We simply were not designed for that.

Why Not Just Index?

This overconfidence leads to the optimistic yet misguided belief that most of us can beat the market. We must believe we can outperform the major indices. Otherwise, the rational thing to do would be to simply buy a major index and forget about it.

A few recent studies support those conclusions. One in USA Today found that most people are no good at investing, and another in The New York Times revealed that people have a poor grasp of basic economics.

Most investors — the 80% who underperform — would probably be better off going the index route. If you’re still interested in trying to outperform — despite all we discussed today — then I admire your gumption. Over the coming months, we will share some tools to do just that.

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Next time, we will take a closer look at the competition. (Be afraid … be very afraid.)