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Copyright © 2014 by Tim Richards. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Richards, Tim, 1961-
Investing psychology : the effects of behavioral finance on investment choice and bias / Tim Richards.
pages cm.—(Wiley finance series)
Includes bibliographical references and index.
ISBN 978-1-118-72219-0 (cloth)
1. Investments—Psychological aspects. 2. Finance—Psychological aspects. I. Title.
HG4515.15.R53 2014
332.601′9–dc23
2013050096
To Skyla, Alexa, and Hallie;
for being there always,
as I will always be here for you.
As we move forward through the twenty-first century, it's more and more important for investors to understand the unconscious drivers that affect the way they make decisions about money because increasingly we're being left to fend for ourselves. It wasn't so long ago that retirees could look forward to a comfortable old age supported by employee sponsored, defined benefit pension plans and a generous social security system. Those days have gone, and more often than not we're being left to make our own investing decisions using 401(k) plans and other individually managed accounts.
At the same time, a vast expansion of the financial services industry has put us in charge of many more financial decisions—no longer are we limited in how much we can borrow by a wise old bank manager, but we are left to decide how much we can repay—and we must take the consequences when these decisions go wrong. This is especially so as a huge industry has grown up to exploit our biases, in order to part us from our money. The securities industry is a gigantic machine for extracting money from ordinary investors, and does so in a way that makes it all seem perfectly reasonable.
All this is happening as lifespans are lengthening due to improvements in medical care and a better understanding of healthy living. So the decisions we make about our money will determine whether our lengthening old ages are played out in comfort or misery. Learning how, and why, we make these decisions, and how we can improve them, should be a priority for all of us.
Although we've been given greater freedom of choice than ever before, we've not been granted any greater wisdom, or given any training about how to proceed. That's what this book is about, how to use the opportunity we've been given, how to avoid the traps set by our own minds and by those people who want to exploit them. It's a fascinating journey and one, I believe, that will leave you with a permanent advantage over those who don't choose to join us.
Although this is a book with a serious purpose, and is full of carefully chosen academic research to illustrate the points that I want to make, it is not, I hope, a seriously difficult read. Writing an important book that no one reads because it's too difficult and clever would be missing the point: unless this material is accessible to investors and their advisers, it can't help them. Equally, though, I'd urge you not to be fooled by the often light-hearted tone—this is a book with a very serious purpose—to help us figure out how to overcome the enemy within, our own brains. Because if we can't, then we will end up being seriously impoverished.
The book is divided into nine chapters, the first four of which deal with particular aspects of the behavioral flaws that drive us to throw our money at people who are already rich. This is a whistle-stop tour of dozens of different types of behavioral biases, which intends to kick away any illusions you have about yourself and your investing abilities and trample them into the dust.
We start by looking at how our senses often fool us into thinking that there are things going on out there, when they're actually only going on in our heads. Our brains are attuned to the world around us, and they function in a way that gives us the best chance of survival; but these behaviors are often not appropriate when we're investing. Believing that we can influence or even predict markets in a desperate attempt to keep our brains happy is a one-way ticket to penury.
The second chapter looks at how our feelings of self-image and self-worth impact our investing behavior. Far from being careful, emotionless analyzers of financial data, most of us are as concerned about whether it looks like we're good investors as whether we actually are. Above all, we're horribly overoptimistic about our investing talents, and we go to great care to avoid proving that we're wrong: none of which is designed to improve our finances.
We then move onto the tricky subject of situation—the nasty fact that how we invest depends not on rock-solid objective facts but is dependent on the situation we find ourselves in. Sometimes this situation is environmental, sometimes it's other people, but if we're not on our guard it will always influence our investing approach, and usually not in a good way.
The fourth chapter delves into the complex area of social interaction, and the ways that different forms of group behavior can change our investing decisions. It's possible to get people to change their minds simply by modifying the way we ask a question, and this is exploited by a wide range of different influencers, from politicians to corporate managements. We're social animals, and we're very susceptible to social pressures, even though we don't always realize it.
You might think that the various professionals in the securities industry would be better able to resist these different types of behavioral pressure but, as Chapter 5 discusses, the truth is somewhat different. Although many professionals are more capable of managing their biases than private investors, they're exposed to a range of different incentives—and incentives can change behavior, often in ways that aren't in our interests. By all means use a professional money manager, but make sure you know how to manage them.
Although the study of behavioral finance is over 40 years old, in many ways it's still in its infancy and, although increasingly we know what to look for, the techniques for dealing with the problems are lagging behind. In the next chapter we look at some investing methods and how they relate to behavioral bias and discuss some techniques that can be used to help debias our investing decision making. Perhaps the biggest takeaway is that bias will always be with us—it's when we think we've got it cracked that we're most at risk.
In Chapter 7 we develop these ideas around investing methods and debiasing techniques into a method, or rather a methodology, to affect cognitive repairs—in essence, to shore up our dodgy defenses with a method that forces us step-by-step to consider the main issues. Above all, though, this approach is one that emphasizes change rather than stasis—what works today may not work tomorrow and learning to deal with that is a major component in dealing with behavioral issues.
Many of our biases are actually justified by what I describe as myths—ideas that have taken hold of our minds and have become accepted truths. In Chapter 8 I identify a bunch of these and show why we need to question everything. All too often what we believe to be true is not, and refusing to accept any idea unquestioningly is a habit we need to get into if we're going to improve our investing decision making.
Finally, in the last chapter, I round all of this up into seven key takeaways—but I'd urge you not to jump to the end. In this case the journey is every bit as important as the destination, because if you don't know why you need to behave in a certain way you'll never understand what you need to do when the situation you're in changes. And, in investing, the situation changes all the time.
So, let's get started. Let's go meet the enemy: our own brains.