Investing

Your Brain Wasn't Built to Handle Reality

Investors, like political partisans, believe things that haven’t been proven.

Be honest with yourself.

Source: Bettmann/Getty images

Most Republicans -- to be precise, 74 percent, according to a CBS News poll -- think it’s very or somewhat likely Donald Trump’s offices were wiretapped, even though the White House has offered no evidence to back up the president’s claim that his predecessor ordered the monitoring.

I just love data points like this. They say so much about humans as a species -- how we process information, our inability to look dispassionately at a situation, the ever-present cognitive errors, even the challenges of reaching a simple, rational conclusion based on evidence.

There are lessons here for investors who want to better understand how their own minds operate, and how they can manage their own behavior. Each of these bullet points applies equally to the survey respondents cited above and to almost all investors:

No. 1: We seek information to reinforce our beliefs. As investors, we suffer from the endowment effect: We place a higher value on holdings we already own. Hey, if we bought it, then it must be good! I suspect this is due to a combination of wishful thinking and self-validation. Most people don’t really want to find evidence that their investments are a dog; they hate to admit error. Instead, they seek proof that the original purchase decision was correct.

No. 2: Selective perception prevents us from becoming fully informed. Not only do we overvalue what we already own, but we tend to seek out information that confirms the value of that holding. Selective perception and confirmation bias see to it that we overlook evidence to the contrary. 

Take the claim above -- or any investment thesis, for that matter. It should be considered a simple assertion, waiting to be proven or debunked. If you are objective, you should always be seeking and evaluating evidence that disproves your thesis. 

That’s not what typically happens. Instead, we create a filter bubble to reinforce support for our holdings. Rather than having an objective, 360-degree view of our investments, we create huge blind spots. As you might imagine, this can lead to expensive errors.

No. 3: The ability to step out of ourselves to see the world from a different angle or perspective is hard. It’s more than selective perception and confirmation bias: Every buyer should be able to make a case for why that stock should be sold. Every forecaster who predicts a stock-market top should be able to explain why the rally could go on for years. Every pundit who assures us that economic growth will be robust should be able to spot the immediate recession risks.

For every transaction, there are at least two valid points of view: The buyer’s and the seller’s. Investors should take a page from the lawyers and learn how to argue all sides of any investment. You shouldn’t buy or sell anything unless you fully understand the other side of the trade.

No. 4: Emotions get in the way. When we become aware that we may be looking at things in a biased manner, we at least have a chance to overcome errors. However much we may seek this sort of self-awareness, emotions can trip us up. The tribal nature of politics works against us; so too do fear and greed when capital is at risk. Seeing the world without letting our own feelings color perceptions is a never-ending battle.

No. 5: Objectively measuring data isn’t our strong suit. If keeping our emotions under control is difficult, evaluating data is even more challenging. Compelling narratives can easily sway us, even when the facts say otherwise. Sports fans and partisans are so deeply invested in a specific outcome that they simply lose the ability to objectively judge reality.

As an example, when confronted with the lack of evidence for the wiretapping claim above, the pushback was “the lack of evidence does not mean it did not happen.” As physicist Carl Sagan once observed, “Extraordinary claims require extraordinary evidence.” 1

We believe what we want to believe, regardless of the evidence. In the capital markets, the costs of such an approach can be quite expensive.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  1. The alternative leads us to the "Church of the Flying Spaghetti Monster," or the proposition that the universe was created by a flying spaghetti monster. Since you cannot conclusively disprove this, it therefore could be true. The same logic applies above. Sagan argues persuasively that this is faulty logic.

To contact the author of this story:
Barry Ritholtz at britholtz3@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net

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