Cognitive Biases and Financial Investing

Via Delong, Barry Ritholtz on the problems investors face, in

In order to understand how humans invest requires more than the study of economics; one also needs to comprehend behavioral psychology. Combining both cognitive science and behavioral economics can yield powerful insights into the conduct of investors.

I recommend Cornell professor Thomas Gilovich’s book How We Know What Isn’t So to investors all the time. The professor’s contribution to the investment community is his study of human reasoning errors. More specifically, Gilovich studies the inherent biases and faulty thinking endemic to all us humans. These faulty analyses are pretty much hard-wired into our species.

How do these defects manifest themselves? In all too many ways: Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.

We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate “systematic errors” or blind spots in our analytical reasoning.

And that’s only a partial list of analytical imperfections you have inherited.