We are pleased to provide our readers an excerpt from the newly published book Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias by Tim Richards.* The area of investor decision making is a rich one and Tim takes a deep dive into the many ways in which investors unwittingly sabotage their best laid plans. In the book Richards lays out a number of lessons on investing from behavioral finance, the first of which appears below.
Richards is also the author of The Zeitgeist Investor: Unlocking the Mind of the Market. At present he is blogging his way through an alphabetical listing of behavioral biases at The Psy-Fi Blog. In this excerpt from Chapter 2, Richards introduces us to the “introspection illusion” or our tendency to self-edit our lives so as to provide with a stream of positive experiences. The problem arises when our desire to feel good about ourselves tangles with the uncertain outcomes of the stock market.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from Investing Psychology, The Effects of Behavioral Finance on Investment Choice and Bias. Copyright (c) 2014 by Tim Richards.
Chapter 2: Self-Image and Self-Worth
Okay, so we now know that while we can trust our senses to help us determine the future trajectory of a ball we can’t trust them to help us predict the future trajectory of stocks. But we can deal with that, because we’re smart, right?
In fact, we know we’re smarter than the average investor, so we can be pretty sure that we will make money on the markets. After all, if we didn’t think we were going to make money on the markets we wouldn’t be investing, would we?
It’s time to start the tour bus again, because we’ve just strayed into the counterintuitive world of investors’ beliefs about themselves. Only we’d better be careful, because the bus driver almost certainly thinks they’re a better than average driver, along with over 90 percent of other Americans.
We are woefully overconfident about our investing abilities, and we don’t even know it.
The Introspection Illusion
I have two left feet and a cloth ear, which makes me peculiarly unsuited for engaging in any activity that involves music, a sense of rhythm, or the ability to count a beat. Imagine a baby giraffe trying to dance in roller-skates. On ice.
Despite this sad lack of musical ability I don’t hold it against myself, and my own sense of self-worth isn’t particularly damaged by this gaping hole in my abilities. Like most reasonably well-adjusted people, I take a sensible approach to activities I’m not very good at—I avoid them if at all possible and make a joke of them when I can’t. Whenever I have cause to think about my own abilities I do so in terms of the things I think I’m good at, rather than those I think I’m bad at and I certainly don’t start a catalog of my attributes by considering my modern dance skills. And I don’t doubt you do the same.
Go on, make a list of things you’re bad at and then consider whether you care about them?
This is typical of everyone, because no even moderately self-aware adult is going to choose to spend a lot of time doing something that they know they’re bad at, and which is going to provide an unremitting sequence of embarrassing experiences. We actively edit our own lives, and simple self selection ensures that we’ll spend most of our lives doing things we’re at least average at and which provide a positive stream of feedback, which makes us feel good about ourselves. It’s unsurprising, then, that when most of us think about ourselves we generally have a positive self-opinion—after all, most of us have mainly positive experiences to remember once we escape the clutches of our parents, who usually insist on us doing things they’d never consider for themselves. Like modern dance lessons. Not that I’m bitter or anything,
In its most extreme form this preference for favoring one’s self is known as self-serving bias and, at it’s worst, it can lead to a complete failure of introspection. Sufferers will blame their failures on external influences that they couldn’t control and insist that their successes are purely due to their own innate skill. This isn’t an attractive quality at the best of times, but when applied to investing it’s likely to be severely wealth limiting.
Of course, when we do think about ourselves we don’t actually realize that our positive self-regard is generated by our careful selection of activities that make us feel good. We generally recall our triumphs and carefully avoid remembering our failures. This is known as the introspection illusion, and it’s quite probably the reason that we don’t recognize we’re biased, even though we agree everyone else is, why we trade too much and lose a load of money by doing so, why we keep our very worst stocks and sell our best, and why we think we can predict the future, even though the evidence shows we couldn’t predict the present and that mostly we can’t even remember the past. For very good psychological reasons most of us are positive thinkers, especially about ourselves, but this has a terrible affect on our ability to manage our investments. It’s good for our health, but rotten for our wealth.
LESSON 1: Positive thinking is not a positive thing for an investor. We have to deal with the way the world is, not the way we want it to be. Save positivity for other aspects of your life.
Tim Richards is the author of Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias from John Wiley & Sons. This book and ebook is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.
*I provided Richards with a blurb for this book and also received a copy of the book from the publisher.