Improving Investment Decisions
Choosing the path of least resistance can often be useful as a life philosophy, but as an investment approach, it’s a terrible strategy. That’s because taking the path of least resistance – doing what’s easy or convenient – in the world of investments is often unproductive.
Why? Because as human beings, we’re prone to biases that lead to irrational decision-making. We’re often governed by emotions instead of clear thought and analysis when making decisions. It’s no different when it comes to making investment decisions. In fact, there’s a whole psychology field dedicated to studying human behavior and investment decisions called behavioral finance.
First, we’ll dive into the behaviors that lead to bad decision-making, then we’ll dive into what we can do to avoid irrationality to make more sound judgments.
So, what kind of biases lead to bad investment decisions? There are a few main ones.
Availability Bias says humans will believe what they hear and see the most. People who learn about recent plane crashes often overestimate the odds of dying in a plane crash – the same with the lottery. News of the most recent Powerball winners always leads to people rushing out to buy lottery tickets – thinking their odds of winning are greater than they are.
What if I asked you which is the more likely cause of death – shark attack or falling airplane parts? The answer to Nobel prize-winning psychologist Daniel Kahnemann’s question is surprising; falling airplane parts. (In fact, you are 30 times more likely to die from a piece of a falling airplane than you are at the jaws of a shark.) Ahuja, Banerjee, Bendle, “Three Cognitive Traps that Stifle Global Innovation,” Harvard Business Review (October 18, 2013).
Of course, most of us would have guessed shark attacks as the more likely cause of death over falling airplane parts because that’s all we hear about in the news. The same goes for investing. In behavioral finance, investors will invest in what’s easy and convenient and what they hear about, read about, and see the most.
For example, why do investors flock to stocks and crypto? Because these investments get all the press, and they’re what everyone talks about around the water cooler. Besides, it’s never been easier to buy and sell stocks and crypto with free trading platforms like Robinhood.
Herding Behavior and Group Think. This herding behavior goes by other names and variations, but the central theme is the same. Herding behavior, group-think, or the fear of missing out (FOMO), another form of behavioral bias, says investors will do whatever the crowd is doing, whether flocking to a particular stock or running from the exits and liquidating their holdings. Every bubble in the past 25 years can be attributed to herd behavior – magnified by the internet and social media.
During the pandemic, with billions of stimulus money in hand, the investing herds were in full force, snatching up everything from crypto to meme stocks of flailing companies. No investment analysis went into any investment decision-making whatsoever. What could go wrong if everyone else was doing it?
The problem with investing biases is that they lead to irrational decision-making, often based on emotions, which usually leads to poor investment decisions at an individual level and investment bubbles at broader levels.
In the book “Nudge” by Richard H. Thaler & Cass R. Sunstein, the authors dive into what causes humans to make bad investment decisions and what they can do to reprogram their behavior to make better decisions. The authors propose that by making little adjustments/alterations (i.e., nudges), we can train ourselves to avoid bad decisions to make more rational choices and achieve investment success.
The authors focus on one type of nudge in particular – defaults – that are useful in influencing good decision-making. You see examples of defaults in technology. Every time you send an email without a subject line or attachment, you get a prompt asking if you’re sure you want to send the email anyway – the same with deleting files. “Are you sure?” your device will ask you. What if you incorporated “default” nudges into your investment decision-making to avoid mistakes?
Wall Street knows investors are susceptible to behavioral biases and irrational decision-making. It’s in Wall Street’s best interest to encourage high trading volume so they’ll exploit these biases. It’s how bubbles are made, but Wall Street doesn’t care. Bubbles are good for business.
So, how can you use nudges to counter Wall Street’s and the media’s effect on your decision-making?
One way is to give yourself more options or make it harder to choose the bad ones. Another way is to think long-term before making any decisions. Ask yourself how a particular investment action will influence your long-term financial goals. Another valuable nudge is to seek outside advice first. Connect with experienced and successful investors who seem to be free of behavioral biases.
Whatever you do, the point is to do something. And usually, it takes just a simple nudge to steer you in the right investment direction.
Michael Foley, president and CEO of Humabilt Capital, oversees the entitlement process, funding, and operations for Humabuilt Capital. Mr. Foley has been a full-time real estate investor since 1995 during which time he has developed hundreds of single-family homes, townhomes, condominiums, and apartments. Mr. Foley started his investment ventures in Long Beach, California, and has expanded to Apex and Durham North Carolina. Mr. Foley is a graduate of the University of California at San Diego.