Imagine you have spent your entire life chained to a wall in a dark cave. The chains constrain you in such a way that you are unable to turn around to see anything but the cave wall directly in front of you. There is a fire that burns behind you, providing your only source of light. When people, creatures, or objects pass between you and the fire, all you can see are their shadows on the wall. Over time, you recognize certain shapes and associate them with what you think cast the shadows. Eventually, you interpret them into a perception about how the world works.

But what would your view be of “reality” if you were suddenly released from this prison. How strange, or wrong, might the world then appear? This was a question posed long ago by Plato in the Allegory of the Cave. Plato used this story to illustrate how a philosopher, when freed from the shackles of bias, can better understand reality.

In some ways, we are all bound by our bias. Look no further than your social media feeds to see what many of your friends’ “reality” is tied to. These days, it has become almost impossible to keep up with friends’ and relatives’ latest game scores, lost teeth, or birthdays as Facebook has become a forum for sharing “fake” news. Which news is fake? It largely depends on your perception.

If you support immigration reform, you may be more likely to feel emboldened when you see a news story about an undocumented immigrant who has committed a crime. On the other hand, if a news outlet runs a story about how much more expensive some food crops would be if there weren’t migrant laborers, you may stop paying attention or change the channel. This is what is known as confirmation bias, where you have reached a conclusion and then seek out facts that support your belief while ignoring those that don’t.

Investors do this all the time. Many that believe the market is going to fall may give more credence to indicators that fit their bearish narrative. Bulls, however, may cherry pick any good news that bolsters their confidence. The ability to keep an open mind, even to facts that don’t support your world view, can make us better investors and more tolerable “friends”.

Do you feel moved by any of the recent highly publicized and attended protests? Perhaps you were experiencing some herding bias. Investors face similar experiences when there are significant market selloffs, where the tendency is to believe you are the only sucker left that hasn’t sold. Recently, some may be feeling left out as the stock market is hitting new highs seemingly every day.

Following the latest trends, social pressure to conform, or the mistaken belief that a large group must be right are all reasons herd bias happens. Recognizing the tendency to follow the crowd may help you avoid getting trampled.

Excited about making America great again? It’s not unusual to believe we are more likely to be successful (or less likely to fail) than probabilities or ultimate results suggest. For example, a 1977 survey of college professors showed 94% believed their work was above average.[i]  Many other studies have shown similar overconfidence, from college students believing they will outlive their peers[ii], business leaders that their company is more likely to succeed[iii], to people avoiding flu shots due to the belief they are less likely to contract the bug.[iv]

This is known as optimism bias, and similarly, investors suffer from it as well. Overconfidence in dot com stocks in the late 90’s and financials in the mid-2000’s led to two of the worst bear markets in generations. In fact, studies have shown that stock pickers commonly believe their purchases will do better than average.[v] 

Confidence can be a great thing when you are stepping into the batter’s box or going in for a big job interview. Failing to recognize when that optimism has risen to excess can lead to expensive mistakes and failures.

What all of this tells us is that we’re all biased, it’s how we’re wired. By being aware that we are inclined to act in ways that are counter to our intellect, judgment, and even our values, we can come out of the shadows and actually see the light.

[i] Cross, P. (1977). Not can but will college teaching be improved? New Directions for Higher Education

[ii] Weinstein, N.D. (1980). Unrealistic optimism about future life events. Journal of Personality and Social Psychology

[iii] Cooper, A.C., Woo, C.Y., & Dunkelberg, W.C. (1988). Entrepreneurs’ perceived chances for success. Journal of Business Venturing; Larwood, L., & Whittaker, W. (1977). Managerial myopia: Self-serving biases in organizational planning. Journal of Applied Psychology

[iv] Larwood, L. (1978). Swine flu: A field study of self-serving biases. Journal of Applied Social Psychology

[v] Odean, T. (1998). Volume, volatility, price, and profit when all traders are above average. Journal of Finance