July 22, 2007

Reality-Based Investing

The human mind is vulnerable to a variety of biases, cognitive errors, and the like. Primitive superstitions, such as religious belief, are particularly fascinating examples, but they are hardly the only one. The ritualistic behaviors of baseball players, buying lottery tickets and other forms of gambling, the "hot hand" phenomenon in basketball, and even most approaches to investing share a common core of irrationality.

It is worth noting at the outset that none of us are immune to making the sort of errors which bias human judgment. Even those of us who readily embrace reason do not always think or act in rational ways. Not the very intelligent, not the nonbeliever, and certainly not me. While we can minimize the damage done by various errors and even learn to defend against them, some level of irrationality will almost certainly creep in.

I have previously described some of the mistakes I made with regard to investing strategies and how I took some initial steps toward reality-based investing. More recently, I have discovered an entire field, behavioral finance, devoted to understanding investor behavior. This is as clear a case as I have ever encountered of the worst enemy of the investor being the investor's own psychology. Just as the vulnerabilities of the human mind open the door to religion, they open the door to a host of awful investment decisions.

As a quick and simple example, consider that the typical investor buys when the market is already going up, after he or she has been bombarded with media hype. In other words, the investor buys when prices are high. And what does he or she buy? The top performing investment vehicles of the past year, past 5 years, etc. Not only are these investments likely to be overpriced, but the data show that past performance does not predict future performance. As if that wasn't bad enough, the phenomenon of mean-reversion suggests that yesterdays top performers will be more likely to be tomorrow's worst.

Reality-based investing is actually quite simple. The basic principle involves allowing one to be guided by the data rather than by one's emotion. This means that the reality-based investor utilizes no-load index funds and does not hold shares of individual stocks or actively-managed funds. Market timing is avoided, as is the bulk of the finance media.

The more I study investing, the more parallels I see between typical investor behavior and that of religious believers. Not only is the irrationality not avoided, it is celebrated, hyped, and sold to a gullible and largely ignorant public. Breaking free from irrational belief in investing is not that different from doing it with regard to religion.

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