While sessions on emerging markets and small cap investments reminded attendees at the Benefits Canada’s 2012 Defined Benefit Summit to look at familiar investment classes with fresh eyes, another presentation Ryan Taliaferro, senior vice-president and portfolio manager/researcher with Acadian Asset Management LLC, tackled the issue of psychological habits even more directly. Here are some examples of common psychological traps to avoid.
Seeing patterns where they don’t exist
Using the famous Kjell Sandved photograph whereby butterfly wings seem to spell out letters of the alphabet, Taliaferro reminded us that our brains are wired to detect patterns even when they aren’t there. One way to fight that urge is to question patterns and find out the story behind the numbers. “An excellent complement for sound statistical analysis is to always have an explanation as to why,” said Taliaferro.
Categorizing rather than analyzing
Another shortcut our minds tend to indulge in is skipping over specifics in favour of categories. Taliaferro recalled the example of a colleague at Harvard who had asked separate groups of students to guess the temperature spread between two identical time spans, March 12 and March 24, and March 24 and April 5. In spite of the identical number of days in each span, students predicted the temperature would be almost twice as high in the second range.
“The April 5 date inherited attributes of ‘April-ness’ and the March date inherited ‘March-ness,’ and everyone knows April is much warmer than March,” said Taliaferro.
He related the prevalence of such categorizing to stocks by pointing out the values we assign to tech stocks, growth stocks or even the category of “stock” itself. “If you use the same rate for all stocks you will systematically overprice the risky ones and underprice the low-risk ones,” said Taliaferro.
Getting caught up in the search for the next Google
Taliaferro pointed out that human beings are relatively poor at processing low probability events; for instance, equating million-to-one odds with billion-to-one odds even though the difference is significant. By focusing on the prize rather than the risk, even smart investors leave themselves open to unduly precarious decisions by searching for “the tiny garage company that will become next Google.” Which can lead to a willingness to overpay for risk, a move not unlike playing the lottery.
Suzanne Bowness is a freelance writer based in Toronto. firstname.lastname@example.org