Behavioral Finance

You Gotta Believe

Human minds are built to act on beliefs and assumptions—a very dangerous thing for successful investing.

I'll make you a bet. I'll wager the vast majority of your decisions are made on beliefs and not facts.

What, don't believe me? Convinced you're a perfectly rational human of the modern scientific world? You'd be wrong. Let me explain.

Any scientist worth their salt will tell you we don't know much of anything for sure. That's because in order to know something in the scientific sense, you have to scrutinize it from every angle and test it over and over again until it can't effectively be proven false. Even then, after scores (if not hundreds) of experiments, we still don't "know" if anything's true. All we know in the technical sense is what we think to be true because we can't disprove it. That's how science is done.

That means acquiring real information is extremely expensive, and a simple scientific fact requires a herculean effort of testing and retesting. Truth is so expensive it's impossible to conduct our lives based on things we know to be scientifically factual. We don't have time to wait around for science to prove everything. We've got to live our lives! (If you dumped your mate today, would that be the right choice or the worst mistake of your life? It's impossible to know and pretty darn tough to scientifically test. You're just gonna have to go with your gut.)

That's what life is mostly about: relying predominantly on beliefs and assumptions to make decisions. Life evolved that way. Back in the Stone Age we didn't really know if that mountain lion stalking us from across the field meant to kill us, but was pretty safe to assume he did. So we ran like heck!

Brains are belief machines, and for the most part we get along pretty well with this model. Brains are more comfortable acting on intuition and feeling than taking the time to find proven truths. We even tend to ignore data that goes against our personal experiences and beliefs. That can be bad because often our beliefs are false. According to neuroscientist Andrew Newberg, humans are prone to false memories and beliefs because "beliefs appear to be based primarily on the emotional impact of specific experiences."

So while beliefs and assumptions might be how we conduct our lives, it's a perilous thing for investors.

Sound investing is antipodal to a belief system. It's imperative to act on facts and against intuition. Intuition can lose you a lot of money. Yet, investors' heads are chock full of false beliefs and theories and too many folks act on assumptions and emotions.

Like any scientific endeavor, there's been precious little actually proven when it comes to stock investing. Most economic and market theories are based on incomplete information or assumptions that haven't been rigorously tested enough to know if they're true.

P/E ratios are a classic example. Forever folks have thought P/Es tell you something about how stocks perform. Yet, it's been proven time and again P/Es have no predictive power for stock prices. Even with that knowledge, belief still tends to trump fact and folks scrutinize P/Es all the time in search of the next great stock.

The bottom line is good investing must be approached like a science. Essentially, it's a fight against the brain's natural tendency to act on intuition and belief. That's a tough thing to do, which is why I believe much of investing success is predicated on discipline and humility. If you know your brain can trick you and instead let the data prove your assumptions right or wrong, you've got a great chance of coming out ahead.

Capital markets are still in their infancy and continue to develop at record speed. It's vastly difficult to predict or understand how they function today let alone what they'll develop into ten years from now. But nobody would invest at all unless they thought over time it would lead to positive returns. But how do we know?

Well, you gotta believe.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.