After being burned by one of the worst investment bubbles in history, Isaac Newton reflected. "I can calculate the movement of the stars, but not the madness of men."
That's just as true today. It doesn't matter how smart you are. You'll be broke before long if you don't have the right mind-set.
As markets continue to bleed investors dry, all of us would do well to stop, take a deep breath, and spend a few minutes thinking about some of the innate biases that lead investors astray.
Here are three.
Recency bias is simply the tendency to think that the future will look like the recent past.
Jason Zweig goes into depth about recency bias in his book Your Money and Your Brain. In the most simplistic terms, the neurons in our brain that hold memories about rewards and punishments from recent events are more active than those of the distant past. "Because your most recent experience carries more weight," Zweig writes, "these neurons evaluate the likelihood of a gain based mainly on the average result of your last five to eight attempts at making money -- with almost all the influence coming from your last three or four tries."
How does this affect investors today? One idea is that with memories of the 2008-2009 market crash still fresh in our minds, investors associate the slightest tingle of weakness as a sign of looming meltdown.
Think about this. One explanation for the recent plunge is that GDP data for the first half of the year was just revised down to 0.8%. That near-zero growth rate worries some that we're slipping back into recession. But GDP growth in middle half of 2006, when the economy was booming, was also 0.8%. Similarly, many cite this year's job growth of just 133,000 per month as a sign we're falling back into recession. But the same figure for a six-month period in 2006 was 115,000 per month.
Those numbers didn't worry anyone in 2006 because what our biases ignore today was well accepted back then: Economies move in fits and starts. The numbers we've seen lately are usually nothing to worry about.
Could we be headed for another collapse? Sure. But recency bias makes us think the odds are far greater than they actually are.
Confirmation bias, as Fool.com managing editor Brian Richards summed up, is the practice of "Googling it until you find something that agrees with your point of view."
President Obama recently gave a good example: "Those of you who are of a Democratic persuasion are only reading The New York Times and watching MSNBC, and if you are on the right, then you're only reading the Wall Street Journal editorial page and watching Fox News."
And if you think now might be a good time to sell stocks, odds are you're only reading analysis that convinces you it's the right thing to do -- even if it comes from sources you're unfamiliar with or disagreed with in the past.
Yale economist Robert Shiller has a way of valuing stocks called the cyclically adjusted P/E ratio, or CAPE (more on CAPE here). The logic behind CAPE is powerful, but it's normally only followed by a small group of investors. One reason why is because, by CAPE's reasoning, stocks have been overvalued for most of the past 20 years, with recent stock prices perhaps 25% above historic averages. Few investors want to hear that, which is why CAPE hasn't caught on among the general public.
Until markets begin cratering, that is. Then, CAPE goes mainstream. A wave of articles in the past week have used CAPE to show how much further stocks will fall. Twitter has been abuzz with investors citing CAPE as a proof of an impending catastrophe. There's no way to prove it, but it seems that interest in CAPE jumps by an order of magnitude during market sell-offs. People who hadn't heard of it a week ago become religious followers.
Maybe that's a good thing. CAPE may very well be right. But the fact that investors don't pay attention to it until markets fall is a testament to confirmation bias. The same is true on the way up. Anyone remember Dow 36,000? We read what we want to hear.
The "everyone else is smarter than me" bias
I don't know if there's an official name for this one, but it's powerful.
When we see markets plunging, we know someone else is selling. You have no idea who that someone is, but if they're selling, and you're not -- Christ, maybe they know something you don't! Instead of asking questions, maybe you should just follow their lead.
Sometimes, that's true. But rarely.
Most market activity is done by algorithms that are simply trying to beat one another. Computers following preset buy-and-sell rules now account for more than 60% of total trading.
These computers have absolutely nothing in common with you or me. They're often trying to get in and out of shares in a few hundredths of a second, literally. You're trying to buy good companies for the long haul. They're trying to skim a fraction of a penny off of each millisecond transaction. Plenty more trading is done by hedge fund managers who have to report results to their clients every 30 days. Daily market moves are dominated by those who think the long term means this evening.
Once you come to terms that these folks have nothing in common with you, not only do big market plunges lose their fear factor, but they become opportunities. My colleague Jeremy Phillips elaborated:
"Please, Wall Street! Sell off a great company because it missed your quarterly estimates or because some whiz kid analyst thinks the sector is out of favor. You need to window dress the next quarter, I need to fund my retirement in 20 years. I certainly like my odds, regardless of what you choose to do in the short term."
Let the self-proclaimed genius Wall Street traders torpedo markets in the short run. Take advantage of them when they do. They might be able to calculate the movement of the stars, but you can calculate the madness of their behavior.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
Fool contributor Morgan Housel doesn't own any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
At the time this article was published
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.