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TheStreet Open House

Apprenticed Investor: Know Thyself

Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it's not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.

The problem, it seems, is a design flaw.

Indeed, many classic investor errors -- overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up -- are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.

Why is that? The problems lay primarily in our large mammalian brains. It is actually better at some things than you may realize, but (unfortunately) much worse at many others you are unaware of. Most people are unaware they even have these (for lack of a better word) "defects." The fact is, when it comes to investing, humans just ain't built for it.

Psychology Vs. Economics

In order to understand how humans invest requires more than the study of economics; one also needs to comprehend behavioral psychology. Combining both cognitive science and behavioral economics can yield powerful insights into the conduct of investors.

I recommend Cornell professor Thomas Gilovich's book How We Know What Isn't So to investors all the time. The professor's contribution to the investment community is his study of human reasoning errors. More specifically, Gilovich studies the inherent biases and faulty thinking endemic to all us humans. These faulty analyses are pretty much hard-wired into our species.

How do these defects manifest themselves? In all too many ways: Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.

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