So I was sitting next to a young couple in a café the other day. She started reading his horoscope to him.
Her: “Big week for reconnecting with family. A sustained effort over the past 6 months will begin to bear fruit this week,” she said.
Him: “Wow. That’s spot on. I’ve got a good feeling about this week.”
Her: “Oh hang on. This is last week’s paper… What was your week like last week?”
Him: “Oh, nothing like that. I was sick in bed all week.”
Humans are funny. We effectively have the most powerful computer ever invented working around the clock inside our heads. It is capable of 10 to the 16 processes per second (lots), but we still can’t stop it from making basic mistakes.
Like the Barnum effect.
The Barnum effect describes the tendency for people, like our young mate in the café, to give greater credence to vague and general observations when they’re applied to themselves, and to regard them as personally applicable. (It’s named after the famous circus promoter P.T Barnum who claimed “We’ve got something for everyone”.)
It’s just one of a number of useful observations coming out of the field of behavioural economics. The science of psychology and choice, it trades grand economic theories for actual studies of how humans work.
As a discipline it’s devoted itself to explaining why people don’t always act like the rational, profit-maximising machines traditional economics assumes we are. For those of us actively engaging with the market, it’s essential reading.
Because at the end of the day, the market is still a mysterious thing. How do these boom and bust cycles keep playing out, over and over again? How can so many people in the market keep getting it so wrong?
Traditional economics can’t explain why, if you’re a herd investor, following the market and only playing ‘safe bets’, you get burnt every time.
The herd never learns. It keeps running over the same old cliffs.
It’s an obvious point, but to make real money as an investor, you need to buy when the market’s cheap, and sell when it starts getting too expensive. It takes courage to break with the herd, but it also requires an understanding of why, how and when the herd gets it wrong.
Let me give you a few more important ‘cognitive biases’ like the Barnum effect.
The first is a negativity bias. That describes that handy evolutionary trait that we tend to regard bad news as more important or more profound than good news. The brain says “Pay attention! Sabre-tooth tigers are bad.” This bias explains why our news services are overwhelming weighted towards bad news, particularly disasters.
A similar slant is with the salience bias. This describes the tendency for people to spend more time worrying about ‘big-impact’ events than they need to. It explains our fascination with natural disasters and terrorists attacks, but out seeming indifference to skin cancer and road accidents.
It also explains why many people are afraid of flying but I’ve never heard of anyone who’s afraid of getting in a car. It happens even though we know that the chance of being killed in a road accident (about 1 in 84) is far greater than the chance of being killed in an air crash (about 1 in 20,000).
The last bias that I think is worth mentioning is the recency bias. This describes the tendency to place more weight on more recent events, and discount events in the distant past.
This is why lawyers schedule their most influential witnesses at the end of proceedings, rather than the beginning – why your opinion of a restaurant is overwhelming influenced by the last meal you ate there.
There are dozens more and we could go on an on. But why have I pulled out these biases in particular?
I think you can probably guess where I’m going.
All of these factors help explain why the herd always misses the downside turn. (A different set help explain it on the upside.)
And so you still hear people wondering when the property market’s going to bottom…
Mate! Look at the price data. It happened 9 months ago. It’s old news.
But people can’t let it go. People’s expectations have adjusted to the post-GFC penny-pinching. They forget that the market moves in cycles and believe that the hard times are here to stay (recency bias). They are on the constant look out for bad press (negativity bias) and the media is happy to give it to them.
And people worry that the housing market will collapse into worthless rubble at any moment (salience bias), even though the fundamentals are strong, and price growth, rent to incomes, debt to GDP etc all read ‘system normal’.
The herd is behind the curve.
(I should make that into a t-shirt.)
The herd is behind the curve.
And right now, it explains why confidence has been so slow to turn with the market. Only now are we starting to see consumer and housing confidence reflect the reality of conditions.
Westpac consumer confidence for example was up 2 percent in March, following a 7 percent jump in February. It takes the index to the highest level since December 2010 and to a decent 15 percent higher than a year ago.
Importantly for the housing market, the ‘now is a good time to buy a dwelling’ index has also increased 19.6 percent over the past year.
We’re not back at boom levels yet, but the herd is slowly catching on. The housing apocalypse never happened, the great Australian economic meltdown was cancelled, and things are, surprisingly, actually looking pretty peachy.
And so, with the herd rounding the turn, the window is closing for clever (rational?) investors like you and I. The herd is waking up. They’re breaking free of the shackles of their cognitive biases, and they’re coming back to market.
Now is the time to get active.
Leave it too late and you could get trampled in the rush.