Vanguard.com has an interview with Jason Zweig, Money magazine columnist and author of the book Your Money & Your Brain.
He notes that the way we perceive patterns and evaluate risk is well-adapted to the physical world but poorly adapted to the financial world. I would add that we are poorly adapted to the policy world as well.
Some of his points:
- We perceive patterns too fast, after only two or three instances. Thus, when a stock rises two days in a row, our brains tell us it is a real trend when it is most likely just noise.
- We over estimate our own understanding. Thus we “explain” daily stock variation by pointing to single events (a government announcement or weather event).
- We react emotionally to certain kinds of risk and are blind to others. Thus, when a stock drops two days in a row, we respond with fear and may make bad disinvestment decisions. Yet when we over invest in one stock (far more risky than a two day drop), we feel no fear at all.
I think these traits drive a lot of policy decisions as well. Consider how often we pass laws in response to a single event (the crime-of-the-month phenomena) or ignore poor public management systems until they cause a crisis.
Two current examples of this are the attention to food prices and oil prices. Both of these are long-term issues with complex causes and competing goals. Over-perceiving patterns, over-estimating our understanding, and reacting emotionally will probably not yield good policy.
Balancing emotions and investing decisions. Transcript available here.
