Can We Correct Our Own Biases?

Earlier this month, I quoted this statement from Alan Greenspan (emphasis mine):

"...these models do not fully capture what I believe has been, to date, only a peripheral addendum to... financial modelling - the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve."

In describing the wild market fluctuations that come with booms and busts, Greenspan was referring to the behavior of masses, but what about individuals? Once we realize that some of our behavior is irrational or inefficient, do we work to overcome it -- especially when there is lots of money involved?

To find out, Lukas Menkhoff and Marina Nikiforow of the University of Hannover in Germany surveyed roughly 100 German money managers.

They first identified whether the manager was a believer in behavioral finance -- i.e. aware of potential biases -- or not. They found that about 1/3 of the German managers believed strongly in the existence of some or all of the following documented examples of irrational behavior: the house money effect, confirmation bias, reflection bias, home bias, and herding. Interestingly, there was no demographic differences between believers and non-believers (in categories like age, sex, or education). For a list of all known biases go here.

Strikingly, there was no difference between how the two groups viewed themselves, meaning that believers didn't believe they fell prey to the biases -- which is kind of like believing that your chances of getting cancer are low even if both of your parents, and your siblings, have gotten it.

There were a couple of bright spots however. First, both groups were asked to predict, within a range, where the DAX stock index would be in a month. Believers gave a much wider ranges than non-believers. The researchers interpreted this to mean believers had done a better job of learning from their previous mistakes.

Second, believers were also more likely use non-efficient market friendly strategies like technical and contrarian trading.

Overall, though, the findings are pessimistic in that it looks like recognizing the fact that markets are inefficient and acting to overcome that don't necessarily go hand-in-hand.

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