We’re Not Perfect

Imagine the Masters has finished in a tie: Tiger Woods and Phil Mickelson are heading to a playoff. All Phil needs to win is a putt. You rush over to the next hole to find the perfect spot in case he misses. Then, suddenly, you hear the roar of thousands of people. Phil has just earned another green jacket! "What was I thinking?!" you mumble to yourself as you head home.

What explains peoples' inevitable deviation from rational thought? According to the author of Against the Gods, Peter Bernstein, these deviations can be explained by decision regret, endowment effect, and myopia In fact all are applicable, in some form, to the most rational investors.

David Bell explains that decision regret is "the result of focusing on the assets you might have had if you had made the right decision." From an investor's standpoint, for example, decision regret comes from selling stock and watching it sky rocket soon after. This, then, promotes the irrational behavior of selling low and buying high.

The endowment effect is another human flaw that leads to irrational behavior. Richard Thaler defines this phenomenon as "our tendency to set a higher selling price on what we own than what we would pay for the identical item if we did not own it." This makes sense as irrational because an investor’s price to sell is different than his price to buy – whether you own it or not should not matter.

The final human flaw is myopic sight: not being able to see far enough into the future to make rational decisions. This concept is of particular importance to investors in volatile stock markets, mainly because stocks do not have a maturity date. A volatile stock market is an environment that, Bernstein states, is "nothing more than bets on the future, which is full of surprises."

Ever since Daniel Bernoulli's thoughts on utility and risk aversion in the 18th century, behavioral economics has been studying irrational behavior. It is understood that not all investors will follow the same rational model. If they did, then everyone’s investment portfolios would look exactly the same. There has to be winners and losers in investing. However, if irrational thought can be deterred then one just might catch the game winning putt.