I have seen the enemy and it is us!

“Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street.”

Vividly I can recall the dot com boom when technology related companies showed no or little profit and yet were being valued at astronomical prices. It was called a new era when valuations did not matter. Investors seemed to put their “senses” away. The question that I reflected on was, how did such a “crazy” thing take place in the modern day, when we were supposedly more advanced and knowledgeable than previous generations? The simple conclusion, people have not changed.

This idea has given birth to a field of study called Behavioural Economics. It is a growing area of study and application. Interestingly, Daniel Kahneman (a psychologist) received a Nobel Prize for Economics, for his work in this area. By identifying these hard wired biases he could understand better than traditional economics what decisions humans would make. It seems that these biases are innate and have played a role in our evolutionary history.

Some brief behavioural examples:

– The impulse to find comfort in crowds, also known as herding.

– We selectively move towards those ideas which agree with our pre-existing expectations, and ignore things that disagree with our beliefs.

– We are vulnerable to anecdotes (i.e. unsupported by data) that mislead (as they tend to be easy to understand) – thus the tendency to easily be taken in by headlines

– Too many choices causes confusion and procrastination

So we have some hard wired biases (except maybe Jery), that we don’t know we have! How do we get around these biases so they don’t interfere in a negative way with our planning? I believe process is one major way. Building a structured framework around how we intend to develop strategies and to invest, helps to remove some of the effects of the mental biases. Another very important one is: Being open to ideas that conflict with our own.

Our wiring must be the same across generations and the biases are not easily managed or ironed out. Be aware of these and you will be ahead of the “herd”. Simply, “know thyself”.

Oh, and repetitions don’t just happen on Wall Street!

If you would like to learn more about behavioural biases click on this link to watch the slide presentation http://www.dfaau.com/2009/12/behavioral-biases.html