Human Irrationality and Investment

As the battle between passive and active investing rages on and evidence continues to pile up to support the use of indexing strategies over picking stocks, investors continue to trade excessively in hopes of beating the market. Even worse, some pay exorbitant fees to managers that continually underperform. So, why do people continue to invest this way? This article from the Wall Street Journal suggests that this seemingly irrational behaviour can be explained by human nature. Investors make mental mistakes when trying to make decisions that are often erroneous and lead to suboptimal outcomes. The author suggests that mental errors such as the framing, overconfidence, hindsight, and confirmation biases may explain a large part of the reason why humans are compelled to invest as they do. However, he also attributes a portion of this behaviour to “the thrill of the chase.” The human desire to do something and the notion that effort should lead to something of value can be a major incentive for investors to dedicate time to trying to beat the market, no matter how insurmountable the odds may be.

We understand that our natural behavioural biases can lead to suboptimal decision making. In something as complex and as competitive as financial markets, this effect is exacerbated. We believe strongly that decisions should be made far before action is required. In our opinion, this can be accomplished by using systematic, rather than discretionary, trading and portfolio management rules. Making a choice about how you should act in “cold blood” – or before you are presented with potentially emotional decisions – helps take a lot of the bias of decision making out of the equation. You can further guard against your own human nature by using systematic rules that are based on rigorous and evidence-based research. In the end, as humans, we will all inevitably fall victim to our biases, but there are steps that can be taken to minimize their impact.