Psychology Vs. EconomicsIn 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
What Have You Learned in the Past 2 Seconds?Let's place these defects into a historical framework within the context of the capital markets. My favorite illustration as to why humans simply aren't hard-wired to undertake risk/reward analysis in capital markets comes from Michael Mauboussin, Legg Mason Funds' chief investment strategist. Mauboussin takes our evolutionary argument -- the mind is better suited for hunting and gathering than it is for understanding Bayesian analysis -- and places it into a chronological context. In an article titled What Have You Learned in the Past 2 Seconds?", he creates a timeline of human history scaled to equal one day. He starts at the beginning: Homosapiens came into existence 2 million years ago. Next, Mitochondrial Eve, the common female ancestor among all living humans, lived less than 200,000 years ago. Last, he notes that modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago. If all of human history were a day long, then investing is only about two seconds old. Is it any surprise that most humans do it so poorly? The vast majority of human history has been spent learning to survive, not analyze P/E ratios. Learning to fight nature won't be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you'll have to overcome your ego's predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).
Why Not Just Index?This overconfidence leads to the optimistic yet misguided belief that most of us can beat the market. We must believe we can outperform the major indices. Otherwise, the rational thing to do would be to simply buy a major index and forget about it. A few recent studies support those conclusions. One in USA Today found that most people are no good at investing, and another in The New York Times revealed that people have a poor grasp of basic economics. Most investors -- the 80% who underperform -- would probably be better off going the index route. If you're still interested in trying to outperform -- despite all we discussed today -- then I admire your gumption. Over the coming months, we will share some tools to do just that. Next week, we take a closer look at the competition. (Be afraid ... be very afraid.)
|1.||Expect to Be Wrong||2.||Your Fault, Reader|
|3.||The Wrong Crowd||4.||Bull or Bear? Neither|
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Apprenticed Investor series