From the October 2008 issue of Wealth Manager Web • Subscribe!

To the Editor

Asset price bubbles build and burst today much as they have since modern capital markets emerged some 300 years ago. As such, capital markets are often tumultuous and unpredictable. Contributing to this volatility is a market composed of individual investors whose behaviors and judgments sometime lead to poor outcomes and play an important role in market instability. Although solutions to financial crises will not easily be found, a better understanding of common behavioral pitfalls will go far toward mitigating market instability in the future.

Human beings have certain, seemingly ingrained, behaviors that often lead us to make errors in judgment. For example, we tend to look for information that supports our beliefs. This confirmation bias tendency affects how we form our views on the future of markets, which, in turn, can poorly shape our investment portfolios. Such misplaced confidence is obviously dangerous in capital market settings where anything can happen. It is far more important to seek out that which runs counter to our views than that which confirms our views.

A related issue is that investors base their perceptions of the future on what has happened in the recent past. This recent-memory bias leads us to overweight those assets with recent strong performance. For instance, by looking to the recent history of consistently rising real estate prices while ignoring more distant periods of declining prices, investors may hold a false belief that real estate markets always go up in price.

Curiously, we also exhibit overconfidence in our ability to determine outcomes. Such overconfidence leads investors into the fallacious thinking trap that market events are predictable. As an example, amateur male golfers tend to overestimate their driving distance off the tee by some 30 yards. This overconfidence bias gives us the illusion that we fully understand the risks confronting us, when, in fact, we do not. Such overconfidence in our ability to predict the future leads us to take investment risks beyond prudent tolerances.

Consider, too, how our views tend to be strongly influenced by those around us. When we are uncertain about the future, we tend to rely on the collective judgment of others, figuring that our view is no better than our neighbor's. Replacing independent thinking with such groupthink, however, leads to herding and the misplaced enthusiasm found in asset pricing bubbles. Markets, however, are likely to function more smoothly when individuals form their own independent views.

It is easy to see how common cognitive lapses, taken together, can lead to risk postures that eventually feed market crises. Overcoming these common misjudgments, which seem to be embedded in our genetic makeup, certainly presents a challenge. Awareness of our various errors in judgment is a critical first step; acting on this understanding by becoming more deliberate in our decision-making processes is the second. In short, we cannot presume that the past is prologue to the future. The study of behavioral tendencies coalesces into an elegant and compelling package that demonstrates how emotions and cognitive biases factor prominently into poor decision making and even market crises.

In hot pursuit of return, investors also sometimes forget a key tenet of modern portfolio theory--that risk and return must be considered together. Another important response to market aberrations is to broadly diversify investment portfolios across a wide spectrum of asset classes. Proper portfolio diversification will go far toward mitigating the impact of adverse market environments.

Markets are complex systems, and understanding market risk is quite difficult. To cope with this challenge, people often use heuristics, or mental shortcuts, to form their perceptions about risk. These shortcuts can often lead to poor results. Following a disciplined process that seeks to overcome our common errors in judgment will better equip us to contain excessive risk taking and the poor outcomes, such as market crises, that are the result.

Rodney N. Sullivan, CFAHead, PublicationsCFA InstituteCharlottesville, Va.

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