We invest like Dr. McCoy, not like Mr. Spock. As investors, we make bad investment decisions because we are emotional, distractible, impatient, and inconsistent. But that is not our fault. There are things that developed in our primitive brains that do not help us when we have to make decisions about complex matters like investments. Knowing how our brains are hard-wired can help us to avoid the tragic mistakes that we so often make in investing.
Jason Zweig has a piece in the Wall Street Journal about behavioral economics – the study of what we really do as investors and consumers rather than the study of what we would do if we were Mr. Spock (or Lieutenant Commander Data from Star Trek Next Generation). http://www.startrek.com/database_article/spock
One of the biggest problems we have as investors is holding onto bad investments too long. Behavioral economists have studied why we we stick with our bad investment decisions. Here is some of what they have discovered.
One reason we stick with bad investment decisions is that we humans pay attention to evidence that confirms our beliefs and decisions we have already made and we discount evidence that conflicts with our beliefs and actions. That is called the “confirmation bias.” As humans our brains are more receptive to information that confirms that we made good investment choices. The brains of our financial advisors are more receptive to information that confirms that their previous recommendations of investments to us were good ones. Unfortunately, our primitive brains are keeping us for making the right investment decision.
Another reason we stick with bad investment decisions is the “sunk-cost fallacy.” Humans view sunk costs — the money they have already sunk into an investment like a house — as something they have to recover before they will sell. How many people do you know who refuse to move out of their homes until the price goes up enough so they can recover the money they paid for the house? That homeowner might pass up another job because they will not sell a house that is under water.
Even Wall Street investors are loathe to sell a bad investment product when the price is too low — instead holding on in hopes that they will recover their sunk costs. We humans have a powerful urge to maintain a particular investment path in order to avoid experiencing the psychic pain of realizing a loss.
As Economics Nobel Prize Winner Richard Thaler says:
“[E]conomic models were populated with “agents.” These economic agents behave more like robots than humans. They solve problems like a super computer, have the willpower of saint, are free of emotion, and have little regard for their fellow agents. The technical term for these folks is homo economicus but I like to call them Econs.
“Over the past 40 years, along with many colleagues, I have been trying to figure out how to do economics with Humans instead of Econs. We Humans are absent minded, a bit over weight, we procrastinate about saving for retirement, and – crucially – we are influenced by many supposedly irrelevant factors: how questions are phrased, what happened yesterday, what’s the default.
“To be sure, we still need traditional economic theories. But to make accurate predictions we need to enrich those models by adding insights from other social sciences. Incorporating human behavior into economic models improves the accuracy of economics, just as “cryo-electron microscopy” improves the resolution of images in biochemistry.
“Once we acknowledge that humans are fallible creatures, we can ask how to help them make better decisions. As Cass Sunstein and I have argued, we can often do so via simple nudges that point people in the right direction, but don’t force people to do anything.”
In addition to considering “nudges” to remind ourselves to make the right decisions, policymakers need to reconsider many tenets of the law that should reflect that we are Humans — not Econs. Doctrines such as waiver, estoppel, ratification, and mitigation are based upon investors as Econs. Judges, arbitrators, academics, and legislators should reconsider the operation of these and other legal doctrines in the context of investment disputes. But that is not the immediate issue.
For now, investors have to look out for themselves. It is important us to understand how our natural inclinations (our traits as fallible Humans) are used by the financial services industry in marketing, sales pitches, and in litigation. Until the law catches up with behavioral economics research — which could be decades — it is up to investors and advocates to come up with ways to counter the unhelpful hard-wiring in our brains that leads us not only to make bad investment decisions, but to stick with them.
Lisa Bragança recovers losses for investors, protects whistleblowers, and defends individuals and businesses in government investigations and civil litigation.
You can reach Lisa at (847) 906-3460 or Lisa@SECDefenseAttorney.com. You can follow Lisa on Twitter @LisaBraganca.
Disclaimer: This information is for general purposes only and should not be interpreted to indicate a certain result will occur in your specific legal situation. The information on this website is not legal advice and does not create an attorney-client relationship.