No matter how smart, well-educated and informed you might be, you aren’t always rational when it comes to making investment decisions that are good for you. And even knowing that doesn’t always stop you from sabotaging your own financial well-being. Dilip Soman, Professor of Marketing at the Rotman School of Management at University of Toronto, and one of Canada’s leading thinkers in behavioural economics discusses investing blind spots.
Puzzling, but part of the reason something called behavioral economics and finance exists. So here to educate us on why this happens and what we can do about it is Dilip Soman. He's professor of marketing at the Rotman School of Management at the University of Toronto and one of Canada's leading thinkers in behavioral economics. It is great to have you here.
Thank you, Kim.
I think the one thing I thought was fascinating when we talked earlier today is knowing the right thing to do does not mean you will do the right thing. So why is that? Why aren't we wired to do the right thing?
Well, I mean, I think there's a couple of reasons. One is I think we've set the bar too high for being rational. You think about humans, and you think of our ancestors, we were built for collecting the berries, and keeping out the lions and tigers, and doing simple stuff.
Important stuff, but over the years, we've now built a society where we require people to plan for the future and get their medications on time and get their RESPs and RRSPs and compute intertemporal choices, and we just weren't designed to do that.
The human brain is a very simple organ, and it does three things, and it does three things really well. It's context dependent, which means that the decision that you make in a particular context doesn't translate to other contexts. That's important because, oftentimes, in financial markets, we are thinking about decision making in one context, but we are applying it to a different one.
Procrastination. We love to delay stuff. We know what's good for us, but life gets in the way. I've been meaning for years to lose weight and to spend more time with the family and to learn French--
--and save more. Things just get in the way.
And then, finally, something called the status quo bias, the idea that people choose to not choose unless they have to. And these three things combine to make the kind of money mistakes that you're talking about.
So inertia. Just that last one.
- So let's delve into these a little more. And you've got a different number of biases or blindspots, which I understand that, in your world of behavioral finance, people talk about. The first one that we want talk with here, something called escalation bias. What is escalation bias?
So let's imagine the following scenario. You've invested in a stock. You've bought it for $30 a unit. It's now $20. All the signs tell you it's going to go south. What do you do with it?
I hang on to it 'cause I want to. I know this first hand.
You'd not be the only one. And I think the metaphor is simple. When you're in the hole, the last thing you should do is to dig further, but that's exactly what people do. Why do they do that? Because we suffer from something called loss aversion, the idea that when you sell that $30 stock for $20, you're recognizing a loss, and you're psychologically better off not doing that, and that's why people hold on to stocks for a longer period of time.
Escalation simply says you throw in bad money because you've made a prior commitment, and that just keeps escalating over time.
You just don't want to recognize that the pain of actually having a loss is worse than perhaps it might get better.
That's exactly the issue. So people optimistically hang on to penny stocks.
And people do this often.
All the time.
All the time. OK. Another one here is something called the framing effect, and I think when you were talking about context, it reminded me of this.
So the idea behind framing is simple. The idea is that you can take the same information and present that in a different context, and that changes decision making. So think about the following. If you have a particular stock that's not doing well, in the context of that one stock, that might seem like a huge loss. But when you look at that in the context of your entire portfolio, that probably isn't as big a loss. And so the idea is that the narrower your frame, the more likely are you to be sensitive to gains and losses. And so reframing, broadening the frame, thinking about a longer term perspective helps a whole lot.
Let me play this back. So if-- just using your example-- if I put $10,000 into a stock, lost it all, that is terrible. It's heartbreaking. I don't even like saying that.
If I had a $1 million portfolio, and I lose $10,000, even though, absolutely, it's the same number--
It's a drop in the ocean. And so that's the way we want to think about all kinds of financial decisions. Think about saving for retirement. You've planned to save $1 million. You've got a half million in the bank. Now you're at the Starbucks next door, and you say, well, should I spend $5 on a cappuccino, or should I put it in my savings account?
If you're going to frame the $5 in the context of the half million you've got, that's a drop in the ocean. But how much have you saved today for your future? I've saved nothing, and so now the $5 looms larger. So that's the idea of framing.
- Winning streak paradox. What is that?
You know, in basketball, there's something called the hot hand fallacy. If you're shooting baskets, the probability that you would shoot another one, conditioned on the fact that you've just shot a couple, people think is high. Now, it turns out that's probably true for basketball players. There's some muscle memory involved. There's practice.
But the stock market isn't like basketball players. It's like saying I'm going to toss a coin an infinite number of times, and if I've got four heads in a row, well, maybe, I should bet on the head, because that seems to be hot. That's fallacious, right? And so the idea that people think that streaks of outcomes continue longer than they should is the hot hand fallacy or the streak fallacy.
The opposite effect is something called regression to the mean. If you think about several heads that have just happened. The likelihood that a tail is going to be next actually should go up at some level, but that's not the way people think about it.
And so, oftentimes, you've got stocks that are doing well. You sort of keep investing in them with the expectation of this hot hand fallacy when, in fact, over time, it will regress to the mean.
What about-- there is one here that I think in terms of the bias or just that it affects our behavior, sensitivity to noise. I made a note for myself, you and I were talking. There's so much noise right now, and it just makes us-- I'm assuming-- make some really bad decisions. I just say, you know, the presidency of the United States has caused a lot of volatility, and, famously, a lot of people betted one way, and the markets did the opposite.
Well, I mean, noise is exactly one of those big challenges. It causes something called investor overreaction, the idea that people respond to news without actually seeing if that news is going to translate into a tangible outcome. And so noise is a classic example of a situation where humans like to feel like they're reacting. They like to do something-- it's called the action bias.
So hearing all the news and doing nothing about your investments seems like a terrible thing. That's not what people do, right? So we always respond, we fight, we flight. And, you know, reaction to news is no different, so people tend to react to news without confirming the veracity of the news, without confirming what the outcome of that news is really going to be for the markets.
Now, for all the people going, yeah, yeah. I don't do that. I don't do that. That's not something I would do. Let me just put the little context here, because I'm saying that jokingly, because we're all just wired. We can't help but do that. What can you do about this? I mean, how does one person handle that, knowing that I have biases, and I don't make good decisions?
Well, look in the rear view mirror, right? When you drive, you want to see what's around you. And so rear-- R-E-A-R-- is a handy metaphor for, how do we think about helping people make better choices?
The first R is reframing. When you're looking at a particular stock, frame it in the context of your broad portfolio. Frame it in the long term context, not just the short term. That helps a heck of a lot. If the answer is still to sell after you've reframed it, well, maybe that's the right thing to do. But I think thinking through these multiple frames is helpful.
Empathy. Why are we investing? You're investing to help yourself in the future.
So empathy for your future self.
Empathy with your future self is key. And I think we don't have. A lot of people think about investments as this bucket where the money goes, but it's for you.
A, advice. I think it's always helpful to get advice from the outside. As humans, we are always susceptible to emotion. But getting advice from somebody who is not emotionally connected is helpful.
And, finally, reflection. Think through decisions. Never make decisions impulsively. Sleep over stuff. Get feedback. Plan. So REAR, I think, helps people think through making better financial decisions.
And great perspective, as well. I guess I think of this almost-- some people invest themselves. Some people have an advisor. But if you know you're susceptible to things, just getting that coaching like you would in sports or personal training always can be useful.
I think that's exactly right. It's knowing your weakness and making sure you've patched it up with strategies that won't result in a big fall.
Very educational, Dilip. Thanks so much.
Thank you very much.
Dilip Soman. He is a behavioral finance expert and professor of marketing at Rotman School of Management at University of Toronto.