Stop Investing Like Crazy: Using Behavioral Economics to Become a Smarter, Saner Investor
(for Betterment.com)
My favorite economics professor loved this story: "One of the oil men in heaven started a rumor of a gusher down in hell. All the other oil men left in a hurry for hell. As he gets to thinking about the rumor he had started, he says to himself there might be something in it after all. So he leaves for hell in a hurry." It's a perfect example of herd behavior – and one of the reasons I started Betterment.com.
Classical economics assumes that people are rational actors – that they make the best financial decisions possible based on the information they have. But time after time, the market has proven that this just isn't so. If investors were completely rational, we wouldn't have had the dotcom crash or the financial crisis. The history of investing is littered with overvalued stocks and persistent anomalies. Four hundred years ago, the Dutch even had a bubble in tulip prices!
Over the last forty years, researchers like Daniel Kahneman, Dan Ariely and Richard Thaler have created the field of behavioral economics, which investigates exactly how we misinterpret financial information. They've discovered dozens of cognitive biases, from the herd behavior of Sandburg's oil men to hindsight bias and mental anchoring. (We'll be talking about them in the blog over the next few months. There's a LOT of material.)
It's fascinating, and a little scary. If you read too many behavioral econ papers, you start to believe that humans never get anything right. The good news is that there are ways to fight cognitive bias. For instance:
1. Always take the long view. Cognitive biases like overreaction can dominate your thinking in the short term, but once you have accumulated some experience and can take a longer view, their power shrinks. If you're focused on your return five years out, daily price fluctuations aren't as upsetting.
At Betterment, we've chosen our portfolio specifically for the long term. We don't do "in and out" trading, and that lowers the odds of us overreacting to isolated spikes or dips in stock prices.
2. Have someone to disagree with you. Confirmation bias means choosing your facts to suit your theory, instead of coming up with a theory to suit the facts in front of you. The best way to avoid it is to have a loyal opposition: someone who doesn't necessarily agree with your views, and is ready to examine your data piece by piece. (Considering some of the late-night debates we've had at our fund committee meetings, I'm pretty confident in the "opposition" at Betterment.)
3. Enforce your investment discipline. Having investment discipline – a strict set of guidelines that governs when you'll buy and when you'll sell – is crucial for rational investing. It keeps you from panicking when the market falls, and from buying overvalued stock when the market rises. At Betterment, we ask you to invest a minimum amount every month; and since your investment is distributed over a wide basket of stocks and bonds, you won't be spooked by the behavior of any one security.
4. Have a wide knowledge base. This one seems obvious. However, a lot of people try to simplify confusing situations like investing by focusing on only one or two benchmarks; it's called anchoring. (In 2006, anyone who said "God isn't making any more real estate" was anchoring, big time. )
5. Don't assume that tomorrow will be the same as yesterday. Just because a stock is rising, doesn't mean that it will continue to rise – or that it's due for a fall, for that matter. Assuming that past prices determine future prices is the Gambler's Fallacy. It's like assuming that a coin flip will have to land on "heads" because it's been "tails" for the last twelve times.
6. Diversify your portfolio. Of course, this is one of the Ten Commandments of MPT (modern portfolio theory) and there are a lot of reasons for it. But when it comes to behavioral economics, diversification is about avoiding herd behavior. Maintaining the diversity of your portfolio discourages you from following the herd regarding any particular stock or sector. One of the ways we maintain portfolio diversity at Betterment is by investing in exchange-traded funds (ETFs). This gives us a wide exposure to the market as a whole.
And finally-
7. Invest financially, not emotionally. The more emotional you become about your investments, the more likely you are to fall victim to cognitive bias. If you aren't being detached about your portfolio, then invest with professionals. That's what we're here for.
(for Betterment.com)
My favorite economics professor loved this story: "One of the oil men in heaven started a rumor of a gusher down in hell. All the other oil men left in a hurry for hell. As he gets to thinking about the rumor he had started, he says to himself there might be something in it after all. So he leaves for hell in a hurry." It's a perfect example of herd behavior – and one of the reasons I started Betterment.com.
Classical economics assumes that people are rational actors – that they make the best financial decisions possible based on the information they have. But time after time, the market has proven that this just isn't so. If investors were completely rational, we wouldn't have had the dotcom crash or the financial crisis. The history of investing is littered with overvalued stocks and persistent anomalies. Four hundred years ago, the Dutch even had a bubble in tulip prices!
Over the last forty years, researchers like Daniel Kahneman, Dan Ariely and Richard Thaler have created the field of behavioral economics, which investigates exactly how we misinterpret financial information. They've discovered dozens of cognitive biases, from the herd behavior of Sandburg's oil men to hindsight bias and mental anchoring. (We'll be talking about them in the blog over the next few months. There's a LOT of material.)
It's fascinating, and a little scary. If you read too many behavioral econ papers, you start to believe that humans never get anything right. The good news is that there are ways to fight cognitive bias. For instance:
1. Always take the long view. Cognitive biases like overreaction can dominate your thinking in the short term, but once you have accumulated some experience and can take a longer view, their power shrinks. If you're focused on your return five years out, daily price fluctuations aren't as upsetting.
At Betterment, we've chosen our portfolio specifically for the long term. We don't do "in and out" trading, and that lowers the odds of us overreacting to isolated spikes or dips in stock prices.
2. Have someone to disagree with you. Confirmation bias means choosing your facts to suit your theory, instead of coming up with a theory to suit the facts in front of you. The best way to avoid it is to have a loyal opposition: someone who doesn't necessarily agree with your views, and is ready to examine your data piece by piece. (Considering some of the late-night debates we've had at our fund committee meetings, I'm pretty confident in the "opposition" at Betterment.)
3. Enforce your investment discipline. Having investment discipline – a strict set of guidelines that governs when you'll buy and when you'll sell – is crucial for rational investing. It keeps you from panicking when the market falls, and from buying overvalued stock when the market rises. At Betterment, we ask you to invest a minimum amount every month; and since your investment is distributed over a wide basket of stocks and bonds, you won't be spooked by the behavior of any one security.
4. Have a wide knowledge base. This one seems obvious. However, a lot of people try to simplify confusing situations like investing by focusing on only one or two benchmarks; it's called anchoring. (In 2006, anyone who said "God isn't making any more real estate" was anchoring, big time. )
5. Don't assume that tomorrow will be the same as yesterday. Just because a stock is rising, doesn't mean that it will continue to rise – or that it's due for a fall, for that matter. Assuming that past prices determine future prices is the Gambler's Fallacy. It's like assuming that a coin flip will have to land on "heads" because it's been "tails" for the last twelve times.
6. Diversify your portfolio. Of course, this is one of the Ten Commandments of MPT (modern portfolio theory) and there are a lot of reasons for it. But when it comes to behavioral economics, diversification is about avoiding herd behavior. Maintaining the diversity of your portfolio discourages you from following the herd regarding any particular stock or sector. One of the ways we maintain portfolio diversity at Betterment is by investing in exchange-traded funds (ETFs). This gives us a wide exposure to the market as a whole.
And finally-
7. Invest financially, not emotionally. The more emotional you become about your investments, the more likely you are to fall victim to cognitive bias. If you aren't being detached about your portfolio, then invest with professionals. That's what we're here for.