In the article entitled “Before investing: know thyself“, we explored the idea that there is both a sophisticated investor and a naive investor inside you. Want to learn how to identify and thwart your inner naive investor so that your sophisticated investor makes all the investment decisions? myLIFE is here to help.
Richard Thaler, who was awarded the 2017 Nobel prize in economics, has shown that our financial consciousness is made up of two selves: one future-oriented and reflective and the other impulsive and hedonistic. This distinction between a “sophisticated” economic agent and a “naive” one does not imply a difference in levels of education or an inability to make good financial decisions. It is merely intended to help you learn to be honest with yourself and to better understand your relationship with money in order to invest appropriately. To do this, it is important to learn to identify the behaviour of this naive inner being, who will try to influence your decisions at every available opportunity. We have pinpointed some of these behaviours for you, but please be aware that our list is by no means exhaustive.
Beware of the illusion of infallible intuition
Are you struggling to see yourself as a naive investor? That’s perfectly normal. Like most economic agents, your behaviour is probably influenced by overconfidence and a tendency to be too optimistic. When combined, these emotional weaknesses are undoubtedly the single largest source of errors of judgement to consider when deciding to invest.
In his book, Misbehaving, Richard Thaler argues that naivety is much more widespread than it may seem. In his view, “Most of us realise that we have self-control problems, but we underestimate their severity.” His observation that “we are naive about our level of sophistication” is impossible to dispute.
Getting to know yourself better and, above all, identifying your potential weaknesses in terms of judgement and cognitive bias are essential in order to establish a much more realistic image of your investor profile. Making financial investment decisions is a complex exercise, even with the help of experts, because it depends not only on the many variables related to the global economic environment, but also on who you are, your situation and your objectives.
Overconfidence in your ability to analyse these variables effectively may cause you to take too many risks, make too many inappropriate choices, overreact to market rumours and, ultimately, to behave counterproductively and against your own best interests too.
The primary trait of your inner naive investor is that they over rely on intuition when it comes to making decisions.
All of the above enables us to identify the primary trait of your inner naive investor: they over rely on intuition when it comes to making decisions. The key takeaway is that intuition is, in general, a very poor basis on which to determine what type of investor you should ideally become. To keep your intuition in check, you need to rein in your tendency to be overly optimistic and learn to recognise your weaknesses and long-term needs.
Overcoming the excessive optimism illusion
Here’s a quick test for you: would you say you are a good, average or below-average driver? You probably said that you are above average. In fact, 80% of drivers said the same, which makes no sense at all from a statistical point of view. And now you’re probably thinking something along the lines of, “that may be true, but I actually am above average”. Regardless of whether you are or not, this brief exercise simply aims to illustrate the extent to which overconfidence and optimism are common cognitive biases.
The problem is that they affect our judgement and often lead us to believe that we are more skilled than we really are and fully in control of our destiny. So much so that, when our predictions are a long way off the mark, we blame it on bad luck and not on a lack of competence.
Present on a daily basis, these illusions are further exacerbated when it comes to making investment decisions. We need to know how to identify them in order to invest in a more rational way. How can you avoid being so overly optimistic or confident that you end up taking more risks than you really want to? By forcing yourself to consider all the information available and not relying solely on your gut instinct at a given point in time.
Optimists who let themselves be guided by pure intuition tend to ignore objective facts that run counter to their intuitive judgement. As a result, they may decide to embark on investments that will prove to be detrimental in the long run if the best-case scenario does not materialise. Optimists also typically overestimate their financial capacity to cope with adverse situations. Lastly, optimists have the unfortunate tendency to be fooled a little too often by the clustering illusion and forget that “past performance is no guarantee of future performance”.
Escape the clustering illusion
Have you ever convinced yourself that you were on a winning streak? For example, you are in the casino and you win a small amount twice in a row. The third time, you tell yourself that you’re on a winning streak, so you play all your winnings and you lose everything. Afterwards, you blame yourself and wonder why you bet all of your previous winnings. The answer is that you have fallen victim to the clustering illusion, which is often referred to as the “hot hand fallacy”.
The human mind is quick to perceive causal links in sequences of random events.
Let’s apply this to the investment world. Imagine that you make a bit of money by investing small amounts on your own. Do you tell yourself that your luck will hold? If so, you are definitely caught up in the clustering illusion. This is because the human mind is quick to perceive causal links in sequences of random events. Why? Because we are hardwired to believe that a causal factor must be at play in any favourable sequence of events. It is this same illusion that leads traders to continue to invest their earnings over and over again because they have made a number of successful trades in the past.
When they are under the influence of this thought pattern, both the expert trader and the average investor overestimate their capacities and underestimate the statistical element of luck. As a result, they tend to take ill-considered risks. This error of judgement is ubiquitous in finance, leading investors to overreact to any information that is in their favour in the short term, thus encouraging excessive risk-taking in the long term.
Individuals should never take investment risks purely because they have made good investments in the past and are betting that their luck will hold for ever.
Individuals must never take investment risks purely because they have made good investments in the past and are betting that their luck will hold for ever. If you are willing to make risky investments, you must accept that there is an incalculable amount of uncertainty and chance at stake when it comes to the outcome. Adopting this attitude helps to temper intuition and allows you to make informed decisions.
Accepting uncertainty is not a sign of naivety: on the contrary, it is an essential part of a sophisticated investment outlook. Not convinced? Do you know how Harry Markowitz, the 1990 winner of the Nobel prize for economics, decided to invest for his retirement? A first-class sophisticated economic agent, he knew that what was most important to him was to protect his income for the future. He therefore factored in the luck and uncertainty inherent in the financial world. Rather than speculating based on his work, he played it safe and simply decided to allocate his assets to different products by adopting the simplest rule in the world: “Do not put all your eggs in one basket.” Good advice!