Your Financial Enemy Number One: Emotions (part II)

From a purely logical standpoint, it does not make a lot sense to buy a lottery ticket. In a 6/49 game, the probability of hitting the jackpot is 1:14’000’000 or about 0,00051 %. Still, millions play each week.

‘Irrational’ decisions led to the emerge of a field in economics called  ‘behavioral finance’ that explains why we humans tend to make wrong decisions on financial- or property markets over and over again:

1. Confirmation

As individuals, we tend to focus on information that confirms our beliefs. If one believes that the real estate- or stock market is going to rise, we tend to only seek out news and information that supports that position.

This ‘confirmation bias’ is a primary driver of the investing cycle of individuals and creates, by the way, a problem for the media as well.

When financial-  or property markets are rising, presenting non-confirming information would lower the audience and advertising revenues. Thereby, the media tend to strengthen a – potentially dangerous – excess. You surely remember the countless tv-ads of banks for housing-loans during the last months of the property-bubble in Romania.

2. Dice have no memory

As emotionally driven human beings, we tend to put a big amount of weight on previous events. The ‘Gambler’s Fallacy’ is an example.

Consider a series of 3 consecutive rolls of a dice that all came up with a ‘6’. If you predict now, that the chance of another ‘6’ is getting smaller and smaller with each game and thereby bet a lot of money that the next roll wouldn’t come up with a ‘6’ again, that’s ‘Gamber’s Fallacy’.

In fact, the probability of yet another ‘6’ is exactly the same as in the previous 3 games.

Dices have eyes, but no memory.
Each roll of the dice is a complete independent event, which means that any and all previous rolls have no bearing on the future.

This can be extended to investing as many believe that after 3 consecutive market-sessions with gains, a setback is more likely than before and might bet on that expectation.

In fact – on a day to day basis – the stock market is more like a coin flip with the probability of an up- or down day being very close to 50%.

3. Possibility vs Probability

To asses uncertainty and risk, there are ‘Possibilities’ and  ‘Probabilities.’

When the emotion of ‘hope’ is our decision-diver, we tend to the ‘possibility’ to hit the jackpot in the 6/49-lottery.

If ‘fear’ is leading our behavior, we think of ‘probability’. Just because it’s possible that a meteorit hits my house, it does not mean that it’s highly probable.

That’s why so many people, driven by the hope of a good deal, buy expensive stocks or houses that have already shown the biggest increase in price. They believe it’s still ‘possible’ they could move even higher and deny the high probability, that most of the gains are already built into the increase and the risk of a corrective action is rising day by day.

Vice versa in falling markets, when the ‘fear’ of further losses let people to sell at low prices.

4. Go with the Flow

Often unconscious, we humans tend to go with the herd. Much of this behavior relates back to ‘confirmation’ of our decisions but also the need for acceptance.

In life, ‘conforming’ to the norm is not only socially accepted but often expected. In capital markets, this ‘herding’ behavior is what drives markets to excesses and leads to ‘blood on the street’. Whereas moving against the ‘herd’ is often the most profitable action, when it comes to investing.

One of these ‘contrarians’ was John Paulson. He invested against the herd in the US-real estate market and made ‘The Greatest Deal Ever’ as a book about him is titled.

Emotions are a wonderful asset of humans and make all our lives richer.

Just don’t use them as the main driver for your investment decisions. Then, emotions might have the opposite effect.