Monday, December 27, 2010

The Invisible gorilla and investing



Chris Chabris and Daniel Simons have written and engaging book psychology called the The Invisible Gorilla: and Other Ways Our Intuition Deceives Us. This book can be added to the long list of behavioral psychology work that have moved finance away from the pure rational expectations approach.

The main premise is that humans engage in a long list of illusions that affect our judgment. Chabris and Simons focus on six illusions which distort our ability to make good decisions.

  1. The illusion of attention - We often do see what is actually in front of us. Our focus may miss the details which are obvious upon being referenced.
  2. The illusion of memory- We do not remember what actually happened. Our memories are often false even when they are vivid.
  3. The illusion of confidence- We view ourselves as being better than we actually are. The Lake Wobegan effect.
  4. The illusion of knowledge - We think we understand things better than we actually do. We should act more like weather forecasters and express our views or knowledge as probabilities.
  5. The illusion of cause - We often associate correlation with causality.
  6. The illusion of potential - We will often think that we have more potential than we actually do.
Every part of investing is has the potential to be biased based on the set of illusions that are expressed by Chabris and Simons. A key job of any analyst is trying to limit the negative effects of these psychological barriers.

No comments: