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Thursday, 3 March 2016

Behavioral Bias 101: #2 Wishful Thinking

Permanently High

Famously the economist Irving Fisher predicted that stocks had reached a "permanently high plateau", just before the Wall Street Crash. He was talking his own book, having loaded up heavily in stocks. Fisher was engaged in wishful thinking, a cognitive bias that's rife among investors, a notoriously optimistic bunch when it comes to expecting the downright improbable.
Wishes and Wants

Wishful thinking is the idea that whatever we want to be true affects what we believe to be true. Classically Ola Svenson (1) showed that most people think they're better drivers than everyone else:
"In the US sample 93% believed themselves to be more skillful drivers than the median driver"
Oddly enough there's no absolute agreement on why we behave like this. It's not obviously sensible to go around believing things that clearly aren't true. As investors it can be disastrous, as we underestimate risks and overestimate returns, and it's not just private investors who suffer from the problem - Ulrike Malmendier and Geoffrey Tate (2) demonstrated that CEO's just love to overpay for acquisitions, a behavior they explicitly link to overconfidence.

Gains, No Pain

When Guy Mayraz (3) looked at wishful thinking in a financial context he uncovered the perhaps not unsurprising fact that people's expectations of future returns are biased by their situation. People who have a reason to want to see higher prices in the future are more likely to predict higher prices in the future. Well, who'd have thought?

In the context of investors this implies that someone's who's invested in a stock is more likely to expect the price to be higher in future: which is obviously a statement of the obvious, but it seems to be the actual act of investing that makes the difference. Robert Knox and James Inkster (4) uncovered a similar finding in horse race betting, where the mere act of placing a bet improved the punter's confidence in their nag winning, no matter how much of a three-legged long-shot it actually was.

Dissonance

Wishful thinking is built-in to the way we work, so the only way to defend against it is to develop systematic methods to address it; force yourself to consider alternative views, especially alternatives to those of habitually biased insiders. And, if you find yourself fervently defending some favorite stock against opponents don't dismiss their views out of hand: a bit of cognitive dissonance never did anyone any harm. 

Wishful Thinking added to the Big List of Behavioral Biases

Links: over-optimism, self-serving bias, cognitive dissonance

Research:
  1. Are We All Less Risky and More Skillful Than Our Fellow Drivers?
  2. Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction
  3. Wishful Thinking
  4. Postdecision Dissonance at Post Time
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