Behavioral economics (aka behavioral finance) use social, cognitive and emotional factors in understanding how economic decisions may be irrationally limited by one’s focus. The following concepts are most important:
- Heuristics – When an exhaustive search is impractical, people make decisions based on approximate rules of thumb, not strict logic.
- Framing – Anecdotes and stereotypes provide emotional filters that allow information to be packaged in a way that encourages or discourages certain interpretations.
Baird Private Wealth Management recently released a paper entitled “How Your Mind Plays Tricks on You”. Baird frames the decision-making challenge as follows:
A common strategy for estimating unknown information is to start with known information that serves as an anchor or reference point, and then make subsequent adjustments until a more accurate value is obtained. Put simply, this is a crude system of trial and error, often taking place subconsciously. The problem is that we are predisposed to outweigh known information (anchor) regardless of its accuracy or relevance, and any adjustments are usually insufficient in determining a precise result.”
Baird’s paper is worth reading. It describes typical errors made by investors, and how these can be avoided. My summary and interpretation of some of the more important investing tips from the paper (after eliminating or reframing some of Baird’s self-serving comments) include:
- Use numerous benchmarks, rather than relying on more limited statistics.
- Employ objective screens for your decisions. Revisit the application of the screens periodically to your past decisions to address changes in events.
- Keep written records of why a decision was made, and refer back to it to both avoid emotions and learn from mistakes
- Money is the same regardless of its source. Treat all sources of money the same.
- Realize that taking gains (selling winning securities – pleasure) is easier to do than realizing losses (selling losing position- pain). Treat both the same, using a specified formula for evaluation.
- Do not make decisions just because others are doing or recommending something.