Some of our biases are harder to counter than simply changing the frame of the question. In Nobel Prize winner Daniel Kahneman’s Thinking, Fast and Slow, he describes how our brains suffer from overconfidence. This is not so much cockiness—though that’s part of it—as it is our tendency to believe past behaviour to be much more reliable as a predictive factor than we should, and to construct narratives to explain complex phenomena like the stock market even though there are far too many variables affecting a stock’s behaviour for us to really account for.
For example, conventional wisdom holds that the fate of a company is tied to the smarts of its CEO. A CEO’s specific contribution to a company’s overall success is hard to quantify. In order to examine the effect of hiring a rock-star leader to run an existing company, Kahneman compared various pairs of similar firms that had hired CEOs perceived as “strong,” which he defined as one whose strategy had been widely influential. The results suggested that such leaders have only a minuscule effect on a company. “A very generous estimate of the correlation between the success of the firm and the quality of its CEO might be as high as .30, indicating 30% overlap,” Kahneman wrote, noting that the respected CEO would be running the more successful firm in about 60% of the pairs—10 percentage points better than a coin toss.
So, how do you make decisions in light of the fact that, as Barry Ritholtz says, “Our wetware is so poorly wired for capital market investing?” He’s been studying behavioural economics for years, but, unlike many armchair observers, Ritholtz and Fusion IQ have used the lessons of the discipline to inform their investing practice. “What investors don’t seem to get is, this is not like being an accountant or a lawyer or a doctor,” Ritholtz says, echoing Kahneman’s observations that stock markets are too complex to predict accurately. Data amassed by the behaviouralists indicate that experience in stock picking has scant impact on results. “You know, if a lawyer lost half his cases, you’d think he was a terrible lawyer. But if you’re a .400 hitter as a stock picker, hey, you’re an all-star. The way to lose the ego is to say, ‘I am going to be wrong frequently, and occasionally spectacularly so.’”
Another common mistake investors make is to fall prey to what behavioural economists call the recency effect. When a particular investing strategy or market indicator has been successful recently, that is what will come to mind rather than the full panoply of strategies. Unfortunately, complex systems like the stock market produce results for a given action that, more often than not, revert to the statistical mean.
So if the market is largely unpredictable by definition, how do you predict it?
For starters, don’t put too much faith in the predictive power of any one type of analysis. “I use five major metrics: trends, macroeconomic [data] market internals, sentiment and valuation,” Ritholtz says. He then makes a decision based on those factors, while bearing in mind the lessons of behavioural economics. “Here’s the thing I find fascinating: At any given time, three out of the five of those metrics are all but irrelevant.” Market sentiment, for example, is only useful, according to Ritholtz, at the very top or the very bottom of the market.
You also need to set rules for yourself, to combat the sunk-cost fallacy. Most investors know what it feels like to research a company, from its historical earnings down to the size of its factories, and be disappointed when the share price goes in the opposite direction than they had expected. Studies show that it’s hard for our brains to let go when we’ve invested time and/or money in a stock, no matter how much it tanks. If humans were rational, the pain of writing off a loss would be equivalent to the pleasure of an equal-sized gain. But as many investors have already learned, losses are disproportionately more painful to our brains than gains are pleasurable, and many investors sell far too late.