Two of these cognitive errors are simple overconfidence and wishful thinking. We all like to believe that we are better than average and so know more than the average investor. It’s this error that helps explain why growth stocks (those on low yields) have underperformed value (those on higher yields) over the long run. It's because we overestimate our ability to spot future growth and underestimate the extent to which growth is random - which causes us to pay too much for 'growth' stocks.
But there's a lot more. Another reason is that we fail to appreciate emergence. It's easy to look at the typical investor - professional or amateur - and see someone with limited rationality and so infer that markets must be inefficient. But this is a leap of logic. Markets can be rational even if investors are not. This will be the case if they have strong incentives to learn; or if a minority of smart investors can short the stocks they go long of; or if markets select against stupidity causing the stupid money to quickly exit. Such conditions might not exist all the time. But it's silly to assume they never will.
In this sense, stock-pickers make the same mistake that some left-wing critics of market economies do. The latter claim that markets must be flawed because people in them are motivated by greed while not appreciating that - as Adam Smith famously said - selfish motives can produce benign outcomes. Both they and (some) stock-pickers fail to see that market outcomes are not merely individual propensities writ large. Just as nasty people can generate nice markets so stupid ones can generate rational markets. What matters is market structure, not personal propensities.
A further bias is a form of framing effect - in particular what David Navon at the University of Haifa calls egocentric framing. The error here is that when we are thinking of buying a stock we fail to ask: why is the other fellow so keen to sell? What does he know that I don't? As Professor Statman says, we sometimes think of investing as if it were a game of hitting tennis balls against a wall, when it fact it is a game against a skilled opponent.
It is this mistake which generates one common way of losing money - the IPO underperformance effect, the tendency for newly-floated shares to do badly in the months after their listing. One reason why this happens is that investors fail to realise that the owners of the company have inside knowledge of its prospects and choose to sell it at the peak of its fortunes.
Yet another error is the hindsight bias. Take Tesco, for example. It has done badly in the last 12 months because it became too big and unwieldy to respond adequately to the threat from discount supermarkets. In hindsight, this seems obvious. It's natural to infer, therefore, that if only we'd thought carefully enough, we could have anticipated Tesco's troubles.
Again, though, this inference is too hasty. Many things seem obvious with hindsight but are unpredictable in advance. Explanation and prediction are two different things. In failing to appreciate this huge distinction, we tend to overestimate the predictability of share prices.
Finally, there's a selection bias. If your friends or neighbours buy a share that does well, you'll hear about it whereas if they buy a dog you won't. What's more, the tiny minority of companies that grow from nothing into giants are well-known whereas the many that disappear into obscurity get forgotten; Google and Amazon are more salient than boo.com. These biases cause us to overestimate the chances of picking big winners.
There's a cautionary tale here. Cognitive biases do not merely imply that the market is inefficient. They also imply that we can overestimate our chances of beating the market. In this sense, one thing that behavioural finance can explain well is its own popularity.
