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Why investors often lead themselves astray Add to ...

Insights into investing sometimes come from unexpected sources.

Recently, a psychiatrist with whom I share an early morning workout habit forwarded an article in The New York Review of Books by Jerome Groopman, a physician and frequent writer on the challenges of modern day medicine. As I read it, I was struck by the parallels between the things that cause doctors and investors to go wrong.

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Dr. Groopman began by writing that "10 to 15 per cent of all patients either suffer from a delay in making the correct diagnosis or die before the correct diagnosis is made."

The reason is almost never because of technical problems. Rather, it stems from human nature and the difficulty in making good decisions under pressure - "clear thinking cannot be done in haste," he writes. He points to pioneering work by psychologists Amos Tversky and Daniel Kahneman in identifying three biases that cause people to make poor decisions; in 2002, Professor Kahneman received a Nobel prize in economics for this work, the only non-economist to date to receive this honour.

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The perils of anchoring

The first factor that causes doctors and investors to go wrong is "anchoring," the tendency to pick one factor on which to focus and to ignore other evidence.

Professors Tversky and Kahneman pointed out that people intuitively associate higher income and sunshine with happiness. As a result, they dramatically overestimate the impact on happiness of an increase in income or living in warmer climates, even though neither are supported by facts.

Another example might be someone buying a used car, who fixates on the mileage while ignoring the overall condition of the engine.

Doctors can anchor on the first symptom that presents itself, ignoring other problems.

And investors can focus only on a company's share price, only buying when it has dropped from previous levels - neglecting to consider whether there have been changes in the firm's circumstances.

The 'availability effect'

A second aspect of human nature that causes poor decisions is the tendency to extrapolate from high profile or recent events, in other words, easily accessible and "available" data.

For example, due to media coverage when there's a plane crash, some people are reluctant to fly, but they are happy to embark on a long-distance car trip. However, the chances of dying in a car accident are dramatically higher than when flying a similar distance.

An associated problem is that people tend to give more recent information higher weight. So for doctors, recent dramatic cases colour their judgment and cause misdiagnosis. For investors, this leads to a tendency to chase stocks or sectors that have done well in the past while - just think back to the tech bubble, when investors were swept up by the frequent reports of yet another dotcom IPO tripling in the first day of trading.

The cost of attribution

The third bias that causes people to go wrong is the "attribution effect," drawing conclusions from stereotypes, rather than data.

So for example, a doctor may see someone who is obese or a heavy smoker or drinker and immediately leap to conclusions about the causes of their ailment.

Similarly, investors regularly fall victim to stereotypes. For instance, investors often dismiss slow growing "old economy" companies and industries in favour of those with prospects for better growth. Or they dismiss European companies as old, tired and hidebound, unable to compete in today's world.

Neither of these stereotypes is supported by the facts. Research by Jeremy Siegel of Wharton has demonstrated that since the mid-1950s, stock prices of the fastest growing companies has actually underperformed the market as a whole. And over the past 40 years, the European stocks have significantly outperformed both the American and Canadian markets.

Learning from mistakes

After identifying the causes of misdiagnosis, Dr. Groopman went on to write "the most instructive moments are when you are proven wrong, and realize that you believed you knew more than you did."

One of the most costly traits of human nature is overconfidence. That's true of military and political leaders, it's true of CEOs and it's true of doctors and investors.

It's been said of both military commanders and top investors that one of their hallmarks is humility - a constant awareness that they may be wrong. As a result, they're always open to new evidence that contradicts preconceptions and existing views.

These days, many investors and the financial advisers they work with are reflecting on the past couple of years and reshaping their strategies. As part of that process, it's important to think about strategies to avoid traps of human nature that cause both doctors and investors to go wrong. Only by doing that will investors maximize their portfolio returns going forward.

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