Nobel prize-winning economist Daniel Kahneman is at it again. First, he gave us the idea of loss aversion, which states that, generally, we hate losses 2.5x more than we like gains. This was extremely useful because it showed explicitly that investors often behave outside of the traditional "classical" economic scheme. That is, humans aren't always rational and sometimes do things outside their best interests when making decisions.
This discovery, in large part, opened the way for the field of behavioral finance. The idea that our brains are hardwired toward certain behavior, and that we've inherited a wide array of survival instincts from our ancestors through evolution is still an underappreciated fact. But it's absolutely vital to being a good investor.
We're written extensively on this topic before. See our past commentaries and columns:
- Avoid Some Yearend Pitfalls
- Neuroeconomics: "Metaphors We Invest By"
- Brain Discord
- Standard of Misconception
- Reckless Teen Investors
- North Korea Can't Nuke Stocks
- What Happened to the Big Storms?
Now, Mr. Kahneman has made some discoveries about those same sorts of wired-in behaviors and how they manifest in political decisions. Because we believe politics has a significant effect on stock returns, this is a very relevant topic. Yet, in all the financial periodicals we read each week, we could only find this reported in Foreign Policy. Clearly, financial professionals are not taking heed—and that's a mistake.
Why Hawks Win
By Daniel Kahneman, Jonathan Renshon
We advise reading the entire piece, as it gives new insight into how political conflicts work, and also how people in competition (like in capital markets) behave.
"Several well-known laboratory demonstrations have examined the way people assess their adversary's intelligence, willingness to negotiate, and hostility, as well as the way they view their own position. Even when people are aware of the context and possible constraints on another party's behavior, they often do not factor it in when assessing the other side's motives. Yet, people still assume that outside observers grasp the constraints on their own behavior."
Notice how myopic the individual can be: it's almost as if once we believe something we shut everything else out—we very seldom consider other viewpoints. This is a natural psychological disposition, yet potentially dangerous for investors. We must continually ask ourselves how we could be wrong. The more sure we are about something the more it's worth questioning.
"Excessive optimism is one of the most significant biases that psychologists have identified. Psychological research has shown that a large majority of people believe themselves to be smarter, more attractive, and more talented than average, and they commonly overestimate their future success. People are also prone to an "illusion of control": They consistently exaggerate the amount of control they have over outcomes that are important to them—even when the outcomes are in fact random or determined by other forces."
We've cited this one many times before: overconfidence is a classic Stone Age survival strategy and one that lingers in our brain matter even now. But adjunct to this is the important idea of the "illusion of control." Particularly with stock markets, we tend to think we have much more control over things than we actually do.
In truth, one of the central features to all finance and market theory is risk, or uncertainty. By definition, if you're investing, you're giving up control to the possibilities of loss. That's why they call markets "The Great Humiliator" (see our past commentary, "T.G.H."). If you're overconfident, or think you've got control…you'll get humiliated.