The Biased Investor (Part 5)

What does it mean to be rational?

Illustration: Friedrich Blitz. Source: Wikipedia

We need to make decisions every day about all kinds of things: what to eat, what to wear, how to answer the latest question from family members or co-workers or clients. Sometimes, we have time to think things through. Often, however, we don’t have that luxury—so we develop shortcuts, rules-of-thumb, that help us decide what to do pretty quickly. For example, the weather is pretty stable. If slacks and a long-sleeve shirt were comfortable yesterday, chances are they will work again today.

These shortcuts can prejudice our thinking. There’s no exhaustive list of all the different biases out there, but I want to focus on three different types. There’s an effect on our minds that comes from the order things are heard or seen, a preference that comes from our familiarity with certain things—or lack thereof, and a bias that comes from our own attitudes.

The way things are presented to us works in two ways. When we hear a list of items, we tend to remember the first and last item on the list. The first item makes an initial impression, and the last item is still in our short-term memory. Investors are impacted both by “framing’—the way a decision presented to us—and “recency effect”—the tendency to believe that trends and patters we’ve seen in the recent past will tend to continue into the future.

Serial Position Effect. Source: Wikipedia

Familiarity bias comes from our relative comfort with things we have already experienced. This applies to food, sounds, pictures, and just about everything we know. It’s not limited to people. Just exposing fertile chicken eggs to different tones resulted in the chicks choosing to group by the “familiar” sounds after hatching. It’s the reason some advertisers have tried to insert subliminal images into movies and ads—although with varying degrees of success. Familiarity bias leads investors to prefer local companies to ones from different parts of the world, or even different regions of their own country. By this way of thinking, familiarity doesn’t breed contempt, it breeds comfort.

Finally, there are effects that come from our own attitudes. When we want something to be true, we look for evidence that it is true. We’re also not very good at remembering our reasoning at the time of a decision—and the indeterminacy of the future. Researchers call this “hindsight bias.” Everything’s obvious once we know how it turns out. It’s like we have an internal “Yes man.” And we have a preference for the status quo—looking at negative factors more intensely than favorable ones. That’s perhaps why we’re risk averse. If things are working right now, why change anything?

Uriah Heep, Charles Dickens’ “Yes Man”

Illustration: Fred Barnard. Source: Wikipedia

Biased judgements are part of who we are. We need to be constantly on the lookout for them. These prejudices and preferences can affect our decisions so our portfolios are less-than-ideal. If we ignore them, we may fall victim to one more error: the illusion of our own superiority. “The fool doth think he is wise,” Shakespeare writes. “But the wise man knows himself to be a fool.”

Douglas R. Tengdin, CFA

Chief Investment Officer

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