"When examining evidence relevant to a certain belief, people are inclined to see what they expect to see, and conclude what they expect to conclude. Information that is consistent with our pre-existing beliefs is often accepted at face value, whereas evidence that contradicts them is critically scrutinized and discounted. Our beliefs may thus be less responsive than they should to the implications of new information." -- Thomas Gilovich
I've always been fascinated with the abilities of the elite market traders and successful investors, given the challenges they face. Perhaps this comes from the realization of my own bucket-full of biases, tendencies and quirks surrounding how I process, act and react to market moves and information, both in my work-life and personal life.
The implications of emotional involvement impacting effective decision-making are significant as producers evaluate markets in order to make plans for marketing this year's crop, as well as making cropping and pricing plans for next year. A recent report from Rabobank is titled Rebalancing on a Tightrope. While expectations are for continued volatility, the bank expects grain fundamentals to rebalance in 2013 as production increases around the world, moving from what they see as a squeeze in the first six months to a surplus in the second half of the year.
The notion of balancing on a tightrope suggests that things could move in either direction. Is the glass half-full or half empty? Markets are currently focused on South America's production potential, as well as concerns surrounding the drought affecting the U.S. winter wheat growing area. Meanwhile, producers and analysts will undoubtedly interpret this information from different points of view and act accordingly. It will be these differences of opinion which ultimately make the market.
In my early days studying economics, I learned that one of the founding principles of this science is that humans are rational beings and act accordingly. Over time, this principle has been challenged which has led to the field of behavioral economics and behavioral finance as research efforts study the effect of human behavior on the decision-making process.
An example of this is a Bank of Montreal Psychology of Investing Report which was just released which suggests that two-thirds of Canadians are unable to remove the effect of emotions from their investment decisions and also the majority polled have previously acted on impulse. The biggest emotions affecting those polled included anticipation, trust and fear. As well, the report suggests that only 25% of respondents conduct in-depth research when making investment decisions. There was no mention of trends involving these results, although chances are that this is in fact human nature; we've always been this way and always will.
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The Calgary Herald recently ran a piece titled Protect your Portfolio ... from Yourself, which focused on behavioral studies and how behavior affects the decision-making process. The four major pre-dispositions listed include:
-- Aversion to loss: humans have a greater sensitivity to losses as compared to gains. Evaluations can be made too often and many times over too short of a time frame.
-- Overconfidence: There is a tendency to believe that past behavior has a greater predictive role than is really the case. There's also a tendency to create beliefs used to explain complex issues by narrowing the number of variables at play and over-simplifying the problem. Behavioral scientists have identified what they refer to as the recency effect, which suggests that whatever has worked recently will also come to mind first, perhaps eliminating other possible alternatives. Another related bias has been called the sunk-cost fallacy, or the aversion to cutting losses, as our brains are hard-wired to refuse to let go after a bad decision has been made.
-- Confirmation bias: We are all wired in such a way that we seek information and interpret it in a way that confirms our pre-conceived notions. An example given is that a bearish investor is more apt to follow a bearish advisor, or is more apt to interpret news in a bearish fashion. A name given to this is the framing effect, which states that how an issue is framed or presented will affect the solutions our brains will produce. Research has also identified what has been termed the halo effect, which is a belief that certain leaders cannot do wrong, which also fits in this category.
-- Herding: It is natural for humans to follow the herd. Markets are just one example which demonstrates this behavior. Jim Dines, in his book Mass Psychology, points to the split-second change in direction of a flock of birds or school of fish, with no ability for the human eye or even slow motion cameras to identify the under-lying reason or a find a signal of change. In many ways, humans also demonstrate the behavior of moving lock-step with the greater population. We've all seen this take place in the markets.
The good news is that we're all in this together. In his article titled Contain Yourself found in the Report on Business Magazine, Dave Morris suggests that no one is exempt from these biases which are a part of human nature. "You, me, Ben Bernanke and the rest of the human race: We're all in it together."
So the question remains how do you overcome emotion and these natural biases to make more effective decisions? As outlined in the Protect Yourself article:
1) Have a written strategy which outlines objectives, targets and parameters.
2) Own the strategy by understanding the trade-offs between risk and reward and be prepared to act on it.
3) Have rules or limits in place which address concentration on one particular position.
4) Think long term.
5) Be realistic. Realistic expectations are suggested to lead to realistic decisions.
Cliff can be reached at firstname.lastname@example.org
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