The Impact of Bias: Investors, Economists & Analysts
It is how you are wired, a flaw in your wetware, and it consistently trips up your results.
I am not referring to the obvious sentiment extremes — greedily buying in at major tops and selling in a panic at lows. Rather, I am referring to the more insidious ways your brain betrays your objectives as an investor.
I have been exploring this theme for the better part of a decade, and the science has caught up and past many of our worst suspicions. What I am referencing goes beyond Behavioral Economics, which teaches us that the rest of the professions’ basic underlying assumption is in error: No, Humans are not particularly rational economic actors.
The newest research in Cognitive Neuroscience reveals how misleading and incomplete our constructs of reality actually are. What we believe to be true is often far removed from what actually is.
And, it gets worse: Once we have a point of view, especially as a result of owning a position, we are even more inclined to misunderstand the inputs the world presents to us. This typically works to the detriment of our investing performance.
This morning, I want to discuss three examples of these biases:
1. Talking Your Book*: This is a classic example of seeing the world through a lens of your own holdings. You want them to succeed, you root for them to go higher, and this bias impacts your view of everything that occurs around the positions. It still surprises me when I see examples of this bias revealed by some of the world’s best investors. Warren Buffett owns the largest stake in America’s largest mortgage lender. In his annual letter, Buffett claims that banks were “[Victimized by Excesses of Ousted Homeowners](http://www.bloomberg.com/news/2012-02-27/buffett-says-banks-victimized-by-evicted-homeowners-who-emerged-as-winners.html)” who emerged as winners in the foreclosure process. Objectively, banks made loans to people they never should have. They abdicated traditional lending standards because they expected to sell them so quickly the loan quality was irrelevant. These same banks went on a forgery spree, engaging in institutionalized fraud. What do you think was behind Buffett’s WTF moment? Might it have been brought to you by his frustration with a position that perhaps is not working out so well? 2. **Looking for Confirmation*: How many times have we seen a particular point of view reflected not by the facts on the ground, but by the inherent bias caused by specific holdings. The most illustrative example these days is inflation as spotted by holders of Gold.
The Fed is causing not just inflation, but hyper-inflation! Its coming, its here, look at the price of everything going higher!
Except, not so much in the data. But medical care prices are skyrocketing! They have been going up for 2 decades, long before QE. Look at Gasoline prices! Does US/Israeli/Iran saber rattling have anything to do with that? And, gas is still cheaper than pre-crisis peaks.
When you own a specific position, its not just that you see the world differently — you actively hunt out information that confirms that position, while ignoring data that contradicts it.
3. *Expressing Political Views via Portfolio**: There is a sub group of commentators I always find intriguing: The Political Economists. This is a set of people who see the world not through the lens of their portfolio holdings, but rather through the holdings of their political views. The danger of this perspective is to you, the investor. These folks do not care about economic expansion, earnings, or your portfolio gains. They are only concerned with the next election. We were treated to a world class, Harvard Business School case study example last month when NonFarm payrolls were released. CNBC’s [Rick Santelli](http://www.ritholtz.com/blog/?domains=http%3A%2F%2Fwww.ritholtz.com%2F&sitesearch=http%3A%2F%2Fwww.ritholtz.com%2F&cx=015905226837203657063%3Ax1cwdcykvvw&ie=UTF-8&oe=UTF-8&cof=FORID%3A11&s=Search&q=Rick+Santelli&sa.x=0&sa.y=0) went through incredible contortions to explain why last month’s surprisingly good NFP report was [actually terrible](http://www.ritholtz.com/blog/2012/02/no-rick-santelli-and-zero-hedge-one-million-people-did-not-drop-out-of-the-labor-force-last-month/). I suspect a similar bias is why Fox Business channel has failed to become the ratings bonanza that Fox News is: Relentless negativity in the face of a 3 year, 106% SPX rally makes for poor ratings.*
The 3 pounds of 100 billion or so neurons sitting atop your spinal cord is the result of millions of years of evolution. You are likely stuck with your grey matter, and its inherent foibles. We cannot rewire our brains; at least, not anytime soon.
If portfolio managers and investors can at least develop an awareness of their own biases, it will help them understand when they are making decisions based on factors other than their trading methodology.
Indeed, the most one can hope to accomplish is to be enlightened enough to have some degree of self-awareness as to these biases and cognitive deficits. That allows you to at least recognize, and perhaps compensate for, your own errors. Smart investors can quarantine money-losing political pundits as investing news sources.
But, putting politics aside, investors should always seek out different investing perspectivesfrom their own. This include reading economists with differing views, and portfolio managers more bullish and bearish than they — if for no other reason than to understand the other side of your investing thesis.
Its too expensive not to . . .