The Moneyball effect on investment decisions
Have you ever wondered why so many products have an absurd “sticker price” that nobody ever pays? It turns out that even when you know these are meaningless, they can be effective anyway.
Traditional economics used to assume that individuals always make decisions rationally in their own best interests unless there’s some obvious reason not to. The idea that people are predictable as molecules or lab rats was handy for analysis and modeling. But as you might have guessed, and we’ve discussed before, it’s also wrong.
The newish field of behavioral economics focuses on the quirky, counterintuitive behaviors of real people. When it comes to money, these be downright self-defeating. One example is our tendency to stay focused on the first thing we learn about a topic long after it becomes irrelevant. Economists call this anchoring, or focusing.
This is why you often see that inflated sticker price on a purchase. Sure, we know at some level that “a $99 value” may be nonsense. But once it gets in our heads, that number becomes our anchor. When we manage to buy it for $69 we feel clever and successful emotionally – even if our more rational side knows the seller’s cost is less than half that.
This also happens with investments. Let’s say you buy Acme Company stock at $100 per share. Over time its price goes up and down, as the market continuously recalibrates its value based on tangible facts about the business. (Markets can be crazy too, but that’s another story.) Your rational brain understands this. But your emotional self still pegs it at $100. So when Acme gets blown away by the competition and their stock goes into free fall, your irrational sense of it’s “real” value makes you stubbornly hang on for far too long.
Anchoring happens in non-financial decisions, too. In an example made famous by the book and film Moneyball, visionary manager Billy Beane identifies irrational anchoring in baseball’s tradition-bound focus on statistics like RBI and batting average. Instead, he crunches the numbers using more objective, overlooked measures of performance like on-base percentage. With analytical savvy as his secret weapon, he overcomes a meager payroll to build a winning team.
From the traditional culture of baseball to your next trip to the grocery store, anchoring seems to be hard-wired in our brains. In daily life it’s very hard to avoid, even for the most rational people. In financial life, however, there’s an easy solution: don’t let your brain make the decisions! Algorithms don’t have emotions – which is another reason why an automated system, teamed with professional human oversight, may be your best partner for investment advice.
(Photo: By DJ Anto D on Flickr [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons)