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Michael Mauboussin: four common investor biases
When it comes to achieving personal financial goals, you are your own worst enemy. Investors are always held back by common investor biases, which influence decisions and long-term goals.
Both neuroscientists and psychologists have looked into these biases. Combined the two fields of science have established a field of neuroeconomics to understand better how the human brain decodes economic decisions.
One of the goals of neuroeconomics is to understand how certain behaviors are linked to specific brain activity.
In a report published at the beginning of this week, Michael Mauboussin and Dan Callahan, CFA, looked at four key investor biases, which cause investors to make poor choices. In each case, Mauboussin and his colleague looked at what caused the brain to make suboptimal investment decisions and how investors can overcome these biases to improve their decision making.
Social conformity, herding or crowding is the first investor bias Mauboussin covered.
Investor Biases number one: Social conformity
Social conformity comes from our social nature as human beings. Conforming to other social trends encourages others to like you, and can confer loyalty and safety. However, you’re never going to outperform a peer group if everyone owns the same investments.
The science behind social conformity is rather interesting. In the mid-2000s, neuroscientists used functional magnetic resonance imaging (fMRI) technology to pinpoint the mechanisms of social conformity within the brain.
A study by Dr. Greg Berns and his colleagues showed that social conformity is consistent with activity in the occipital and parietal lobes, the visual process regions of the brain associated with perception. The research suggested that different social settings alter what the subjects perceive. What’s more, subjects that remained independent throughout the study showed increased activity in the amygdala -- a part of the brain that decodes emotion and is especially attuned to threats. In other words, independence creates an emotional burden and requires overcoming a wave of fear.
Additional research supports Dr. Berns’ conclusion: social conformity is associated with activity in the part of the brain that detects errors and interacts with other parts of the brain to correct the error. Your brain notices when you’re going against the group and for many, it’s more rewarding to conform than remain independent.
Investor biases two: Pattern seeking
Mauboussin’s second key investor bias is that of pattern seeking. Humans are natural pattern seekers, but when they try to seek out patterns when none are there, problems arise, what statisticians call Type I error.
Technical analysis is a good example of our desire to seek out patterns. We are naturally drawn to imposing order, even in cases where the underlying processes are random. Neuroscientists have looked into this trend and arrived at some interesting conclusions.
"Scientists set up a box with two keys that a pigeon can peck with payoffs that are random. They then make one key much more attractive than the other—for example, the red key provides food with an 80 percent probability and the white key with a 20 percent probability (1 - .80). How will the pigeons choose?
Once the pigeons figure out the relative probabilit