Investment Analysis And Psychological Barriers Investors Face

Investment Analysis
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Michael J. Mauboussin’s latest research report focuses on the topic of comparison. Specifically, how investors can improve their comparison process as part of investment analysis.

The paper, which you can find here, presents an interesting framework for helping to eliminate bias in decision making.

The one thing that stands out for me is the revelation that the primary method of comparison among investors is analogy. As Mauboussin describes:

Analogy is an “inference that if two or more things agree with one another in some respects they will probably agree in others.”

This is interesting because it is dangerous to include a process that’s so dependant on subjectivity in investment analysis. Analogy suggests an emotional approach to picking between stocks, rather than a rules-based qualitative approach. As the paper goes on to explain, analogical thinking has four steps:

“First, we select a source analog that we will use as the basis of comparison with the target. Usually, the source comes from our memory. Second, we map the source to the target to generate inferences. Here, we are often looking for similarities. Third, we assess and modify these inferences to reflect the differences between the source and the target. Finally, we learn from the success or failure of the analogy.”

You don’t have to be a Nobel prize-winning psychologist to see how much scope there is here for your brain to mislead you.

And it’s not just in investing where analogical thinking can lead you down the wrong path. In the information age, it’s all too easy to make a lifestyle or career choice based on misleading analogical thinking.

Second-Level Thinking: What Is It And Why You Need It

The most prominent issue with this way of thinking is that it relies heavily on memories, but not any memories, it is limited to just those memories that you can remember. This, as Mauboussin points out is called the availability bias. Lack of breath prevents us from finding an appropriate analogy.

The availability bias is compounded by other psychological problems, one of which is a lack of depth, or to put it another way, a lack of analysis — an analogy may suggest correlation but fail to identify causality. Correlation doesn’t imply causation. Clayton Christensen, a professor of management at Harvard Business School, uses the fantastic example of man’s quest for flight to describe this:

“The intrepid humans who sought to fly pursued a logical strategy. They fashioned wings covered with feathers, attached them to their arms, went to a high spot, jumped, and flapped. Then they crashed. The attributes of wings and feathers are not enough for flight. Much later, scientists learned how lift, and hence flight, works. The circumstances of flight allow us to fly 350-ton aircraft around the world.”

Another issue is that of “the inferences we draw based on whether we focus on the similarities or the dissimilarities between the source analog and the target.” Called the “contrast model” psychologists have noticed that humans draw different conclusions to the same question based on what they focus on. Studies have shown that just by presenting the same question differently can lead to vastly different answers. Try asking “how much can I lose” before investing rather than “how much do I stand to make.”

The final psychological factor I’m going to pick out that the paper talks about (there are many more) is that of broad vs. narrow framing. The framing effect can result in an investor (or anyone making a decision) making a poor choice based on the way they look at the opportunity or as Mauboussin describes it “Framing is a core idea of prospect theory, which describes the ways we make decisions in the face of risk.”

The Best Way To Manage Investment Risk

Broad framing means that you take into account a risky decision in the context of your total risk as part of your investment analysis. For investors, this could be one position in the context of a whole portfolio. On the other hand, narrow framing says we dwell on the individual risk in isolation and this can push us to make stupid decisions.

Improve your investment analysis

Trying to eliminate these psychological biases from your investment process is laborious and removing them entirely could be all be impossible.

Nonetheless, it is possible to limit their impact and the first stage of doing so it to just be aware that they exist. If you know your mind can trick you into believing certain analogies to arrive a positive result, that already supports your conclusion, you know to double check. Further, by understanding the impact of framing, you can make an effort to eliminate this bias.

This isn’t a definitive guide to the impact of human psychology on investment decisions, but hopefully the above provides some insight you help you refine your investment processes.

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