Humans, perhaps by design, are always too optimistic. For example,  everyone considers their driving to be excellent, notwithstanding massive evidence to the contrary. People think they are smarter, more talented and better looking than they actually are.

In 2007, psychologists Daniel Kahneman (a Nobel laureate) and Jonathon Renshon published a Foreign Policy paper titled “Why Hawks Win”. You can read it here.

In essence, human optimism leads to an overestimate of military strength (and of bravery) and to an underestimate of the opposition’s strength. Just think of how the US is trying to take on Russia, they couldn’t even win in Iraq and Vietnam. This fact, plus a number of other biases, leads Hawks (war and aggression) to dominate Doves (peace and negotiation).

A particularly interesting bias (“a fundamental attribution error” to the psych trade) is where you believe you are acting reasonably while the other side is hostile, and vice versa. This can easily lead to war. Humans are also biased against cutting losses, thus wars often continue much longer than is rational.

These characteristics and biases are critical when making investment decisions. Investment success is often considered to be a direct result of how smart we are. Many investors will not even consider that a successful outcome was random or due to external, unknown forces. Read more here about skill vs. luck in the investment industry.

Most of us have trouble cutting losses. You know the situation, a stock goes down and you keep holding it because it is only a temporary reversal, and anyway it was always going to be a long term hold. Some also buy more on the way down, “averaging down”.

Jesse Livermore is one of the most famous investors of all time. One of his most important rules was to cut losses early. Yet even Jesse was guilty of sometimes holding too long. Read more here.

So the lesson: understand yourself and your biases. They impact investment decision making much more than is generally thought. And remember that you don’t perhaps drive as well as you think.

14 August 2014 Markets