Anyone in the Finance game who hasn’t at least taken Psych101 and/or printed up this list of cognitive biases and posted it on their office/cube wall needs to do so, before its too late. (Its not much, but its a good start.) We may not be able to overcome our evolutionary psychology, but we can educate ourselves and more importantly, consistently remind ourselves of the many and myriad ways our own brains try to sabotage our efforts at objective analysis, no matter how “smart” we believe ourselves to be.
The other day I wondered (on twitter, natch) why so many smart women I know constantly retweet and share their daily horoscopes on Facebook (this of course an evolution of reading them in the daily papers and yapping about them on the phone/in person, whatever). My friend Jim Gobetz was kind enough to send me a link to this fairly fantastic article entitled, “Why Smart People Believe Weird Things,” which, while focusing on more mainstream “weird” things like Bigfoot, organized religion, UFOs etc, has what I think are fairly profound implications for those of us in finance and economics (also law, accounting, and other business fields). This may not be new information for many of you, but to say we need to be constantly reminded of our own mental/psychological/etc is to put it extremely gently.
Most of us are at least reasonably intelligent and educated, I don’t think its even worth debating this fact (the usefulness of either/both is another story for another time), yet even the most seemingly intelligent, educated, resource-endowed, etc make analytical mistakes with startling frequency and sometimes with even more startling magnitude. Thus, I found the following from the aforementioned article well worth considering:
…are the cognitive elite protected against the nonsense that passes for sense in our culture? Is flapdoodle the fodder for only fools? The answer is no. The question is why?
For those of us in the business of debunking bunk and explaining the unexplained, this is what I call the Hard Question: why do smart people believe weird things? My Easy Answer will seem somewhat paradoxical at first:
Smart people believe weird things because they are skilled at defending beliefs they arrived at for non-smart reasons.
We are at times our own worst enemies. If we are not aware of our predilections, tendencies, and biases then we will inevitably fall victim to them. For analysts, we tend to buy too much into the story of the firms we cover, leading us to err on the bullish side regardless of orange or even red flags in the firm’s filings/news/etc. Listen to the analyst questions on almost any earnings call and this is painfully apparent; few (if any) are the truly hard, probing questions. Get it together! A healthy dose of skepticism, regardless of the growth prospects for an industry and/or a particular firm within it, there are ALWAYS things to be concerned about that FAR too often get glossed over if not ignored entirely. As an analyst, you ignore these things at your (and your clients’) peril!
If you’re a trader, anchoring and confirmation bias are probably your two biggest cognitive enemies. Prices have been going up recently, and everyone else seems to agree with the bullish sentiment, so clearly prices will likely continue to rise, right? Maybe, maybe not. Take a step back, don’t just seek out contrary views, seek to understand them and the rationale behind them. If you use momentum strategies, they often work until they don’t; bring other types and sources of information into your trading so you’re not caught with your pants down when the market “unexpectedly” shifts.
All types of professionals, traders, analysts, and investors have a tremendous tendency to stick to their predictions, even in the face of changing fundamentals (technicals, whatever); the ego is very real, and very strong in this business, but ego can lose you just as much, if not more money than it can make you. Confident is good – without conviction in our abilities we’d never get anywhere – cocky is bad, and remaining confident in your predictions despite changes to the variables that affected them is about as bad as you can get. We’re all fairly good at convincing ourselves we are right, but almost all of us can get better at convincing ourselves that we may no longer be so, recognizing that to be the case, and adjusting our behavior accordingly. This is no easy task, but it is a necessary one, so long as you wish to succeed in this business over any sufficiently long term.
