A growing raft of research suggests that the “common sense” of our senses is often … well, nonsense.
It’s why right-handed people favor standing in the right-hand line at McDonald’s, even if lines to the left have fewer people. Or people significantly underestimate a man’s weight if told he is a dancer rather than a truck driver. Or why you are more likely to judge another person as “generous and more caring” if you are holding a warm cup of coffee when you meet them. It’s weird.
And when it comes to money, it’s a problem.
Behavioral finance is showing how traits hard-wired into our biology or encoded into the software of our unconscious mind cause us to stumble with our cash. Our “fight or flight” instinct may have helped us emerge from caves, but it is proving a liability on Wall Street.
There’s nothing you can do to avoid these false notions, researchers say. They are ingrained in us, and must serve a useful function or they wouldn’t have evolved in the first place. But when it comes to money, the key is to “create a set of mechanisms how to control yourself,” as the behavioral economist Meir Statman once told me.
These biases may be wrong, but the good news is they are predictably wrong. Here are a few to watch:
We are very poor losers
Humans feel more pain at losing something than we do joy over a comparable win—losing $1,000 affects us more than gaining $1,000 does. Researchers call this “loss aversion.”
This hard-wiring made sense when our earliest ancestors were trying to survive on the Serengeti. But in the modern world—say, when managing your portfolio—loss aversion can lead to selling a sinking stock when the better long-term play is to hold.
This comes to play in the most basic way the average person participates in the stock market: your 401(k) contributions. Are you topped up to full contribution for yourself and your employer? If not, why not? It’s free money from your employer, tax-exempt and will pay off—down the line. The problem is it feels like we’re losing money from our take-home pay.
One solution: Take it out of our hands with automatic participation. As behavioral economists Cass Sunstein and Richard Thaler note, 401(k) plans where participants need to opt-in have a 68% rate of participation after 36 months of employment; automatic enrollment plans, where participants have to opt-out, have a 98% rate of participation.
We are all above average
We perceive ourselves to live in Garrison Keillor’s Lake Wobegon: “Where all the women are strong, all the men are good looking, and all the children are above average.”
Overconfidence regularly inflates our perception of ourselves and our decisions, researchers say. Studies consistently find that heterosexual men overestimate the number of sexual partners they’ve had, while women underestimate—which mathematically can’t really be true, and perhaps speaks more to cultural expectations (e.g., men are promiscuous, women aren’t) than the facts.
But this tendency can be dangerous in financial markets, as traders found out during the 2008 financial crisis. “Overconfidence is the greatest cause of mistakes for executives … there’s a perception that they kill the weak, and if they show any lack of confidence they can be destroyed,” Joseph Hallinan, Pulitzer Prize-winning journalist and author of “Why We Make Mistakes,” told me in a 2010 interview.
Most Wall Street traders and business executives need to take a lesson from the king of them all: Warren Buffett. “If you read his annual letters, he admits in very plain terms making some big mistakes. That’s amazingly refreshing in the corporate world,” Hallinan said. A dose of humility can go a long way toward ridding ourselves of surplus confidence.
Priming the herd
We don’t see nearly as much as we think. Want to check? Take the test in this video. Follow the instructions very carefully:
If you missed the big reveal on first viewing—as I did—it’s because we were primed to look in a different direction. That’s a trick as old as a magician’s misdirection, but subconscious priming consistently costs us money. Any salesperson worth their salt knows this: When you walk in to buy a car, if you are first shown a model far out of your price range, you tend to ultimately buy a car more expensive than you planned. You were “primed” to pay more cash.
We carry certain tendencies, such as “herding”—literally, following the crowd. That may have once helped humans escape a dangerous predator (there must be some reason everyone is running away), but in today’s financial world it causes us to mistime the market: when to sell low and buy high. Instead, our tendency is to do the reverse. That’s evident in the annual Dalbar survey comparing investor performance with market performance. For the past two decades, the S&P 500 has returned an average of 8.2% a year; yet average investor returns were less than half that.
Nobel laureate Daniel Kahneman, who pioneered behavioral economics with Amos Tversky, writes in his book “Thinking, Fast and Slow” that we operate on two levels: System 1 is intuitive and unconscious, System 2 is deliberate and reasoned. System 1 rules the roost, “although System 2 believes itself to be where the action is,” Kahneman writes.
When System 2 is strong, we catch slips like this: “How many of each animal did Moses have on the Ark?” (Answer: None, because Noah was the captain of that ship. But our knowledge of biblical stories will autocorrect the question in our heads.) We miss stuff like this, large and small, all the time.
What are we to do about it? As this New York Times book review suggests: “For those who are merely interested in Kahneman’s takeaway on the Malcolm Gladwell question it is this: If you’ve had 10,000 hours of training in a predictable, rapid-feedback environment—chess, firefighting, anesthesiology—then blink. In all other cases, think.”
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Illustration by Brian Yee.