Once the intellectuals get a whiff of new psychological theories, look out. With Freud and the "discovery" of the unconscious, the twentieth century wasn't long in the tooth before repression and daddy issues made common cocktail party witticisms. Today, the pattern repeats with the psychology of evolution—there are literally thousands of works circulating on how our natural "instincts" lie at the root of most behavior.
Going all the way back to the 70s, the field of behavioral finance (where evolutionary psychology meets money) has kept a fairly low profile. But in the last decade, particularly these last few years, it's made a leap to the mainstream.
A few weeks back, I wrote a little about the inherent weaknesses in behavioral finance. Popular works like Freakanomics and Predictably Irrational are good entertainment, but be wary—most such books are built on shaky science and are reductive to the point of uselessness. Other prescriptive works like Richard Thaler's Nudge can be borderline dangerous—recommending mass public policy on the basis of such findings.
This is hazardous because, and no matter how much the intelligentsia may crow against this fact, psychology is not a hard science in the same way basic physics or chemistry is. It's not even close, really. We don't understand ourselves yet, and the empirical studies we do are too often overly reductive or poorly executed.
So, the reason it's ill-advised to prescribe policy based on behavioral studies is more or less the same reason socialism ultimately never works: The world is too complex and various, as are human psyches, and the notion that elite rule can consistently fashion the best economic or societal outcomes is nonsense. For better or worse, folks must be free to choose for themselves.
Don't get me wrong—psychology in investing can be hugely useful, and we at MarketMinder use it daily. Indeed, the study of human behavior is at this point a must for market forecasting success. Essentially, the economy constantly changes, even at an accelerating rate, but the human psyche has features to it that are relatively static. Thus, the situations will always be somewhat unique, but the basic patterns of greed, fear, love, hate, and all in between, will out. It's simply fascinating—observing each day how markets move—how fungible human behavior can be. Behavior during a bear market panic transcends time, culture, and place. This is part of what makes global investing truly possible, the baseline commonality of people.
The last two paragraphs may appear contradictory. Well, welcome to psychology! What I believe psychology can do for investors is offer heuristics—"rules of thumb." Unlike, say, the laws of thermodynamics, human psyches are too inscrutable for ironclad rules. People will tend to hate losses more than they enjoy gains (aka prospect theory), but that's not always true. There are tacit patterns, but situational anomalies and exceptions. Economics, as with psychology, loves to study the general, the "norm," the average. But, in fact, we are always living in the specific, the now, this moment. In big systems like economies, specific can be unique. (The paradoxes of moving from the general to the specific are one of the main puzzles, to my view, of market forecasting. But we'll save that discourse for another time.) That there are no ironclad rules should be self evident since no one—ever—can beat the markets every time.
So as investors we must bravely wade into psychology, but tread carefully and be selective about what is trusted. In comes Michael J. Mauboussin—one of the finest writers on behavioral finance today. His current offering, Think Twice, won't get as much fanfare among the intelligentsia as with gurus like Dan Ariely, but ought to. This is a practical book from a real money manager. It's short, clear, light, and makes use of real world examples effectively—as demonstrations of psychological concepts in action rather than literary ornament.
Mauboussin makes an important move most others don't: He links psychology with the study of complex systems (like stock markets) instead of framing it in the light of neoclassical economics. This enables him to make useful observations rather than pointing out where stuff like "rational man" or "equilibrium" theories fall short. Behavioral psychology is at the point where it needs to create better theories, not continually criticize old notions. Let's hope Mauboussin's ethos rubs off on the Academy.
Mauboussin doesn't offer a bunch of rules in the vein of "if X happens, do Y, and then you'll be rich!" What he does, ultimately, is promote self-awareness. Higher consciousness isn't just the stuff of Zen masters. That's the end lesson of all useful psychology outside the pharmacy. Know thyself! Learn to study the quality and method of your decisions, stop focusing so much on the outcome (which, in stock markets often contains much noise and randomness). Seek feedback, ruminate upon your mistakes and successes—understand why you did what you did. Raise your self-awareness.
Investors don't spend enough time mastering their own selves; they believe too much that numbers and metrics have definitive answers. It's a tough thing to do and requires much effort and honesty, but no mathematical valuation metric on earth can replace self knowledge. If next time you don't want to give in to irrational exuberance, or panic at the bear market bottom…figure yourself out. Don't blame the outside world. With this book, Mauboussin offers us the particulars of why this ethos can give rise to smarter investing.
Back in my graduate years, I conversed one night with another psychology student over a few beers: "We've gone past Freud!" she exclaimed. "He was a master, but he doesn't work for us anymore. We have science now." This is folly. As it pertains to psychology, anyway, science (and ironically faith in it) is the great religious impulse of the Modern mind—we want so much to escape our subjectivity and find answers outside, in objective empiricism. Yet, much of psychology's wisdom today can be culled just as easily (often more so!) from the wisdom texts of ages ago. The scientific part of psychology is a noble enough pursuit, but deeper understanding about what makes us human, not the escape from it, has useful answers too. Or, as the old master Carl Jung said, "Unconsciousness of one's true self is the seedbed of sin."