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Investing, and life

One reason for this pattern is that people imitate their peers. If our friends and family are overweight, we are likely to be too - partly because we copy their habits, and partly because others' obesity raises our perceptions of a normal bodyweight; talk of an 'obesity epidemic' isn't mere hyperbole, as obesity really can be infectious. If, on the other hand, are friends are keen exercisers (or, less healthily, are anorexic) we might emulate them and be slim ourselves.

In this sense, peer effects can lead to multiple and extreme equilibria - to some groups being anorexic or hyper-fit while others are dangerously overweight.

But exactly the same is true in stock markets. Hans Hvide at the University of Aberdeen and Per Ostberg of the University of Zurich have shown that people's shareholdings disproportionately resemble those of their colleagues. And Matteo Ploner at the University of Trento has shown that people's appetite for risk is influenced by others' choices.

These are examples of information cascades - of people acting not upon their own private information and tastes, but rather taking their cues from what others are doing. This imitative behaviour can generate excess volatility. Sometimes, investors sell because others sell, causing prices to fall too far. At other times, they buy because others buy, generating bubbles. Just as we see multiple equilibria in bodyweight, so we sometimes see multiple equilibria in stock markets - with periods of excessive under-pricing followed by ones of over-pricing. Of course, we don't see this all the time. Often, shares are reasonably priced, just as many people are of normal weight. The point is, though, that the processes that generate extreme behaviour in diet and in investing are similar.

This tells us that the same forces that affect investment decisions are also evident in everyday life. There are other examples of this.

For example, for much of the autumn most football pundits were adamant that Arsenal couldn't win the league. This is an example of underreaction; having believed that Arsenal were a mediocre team, they were slow to update their opinion in light of evidence of a big improvement.

Exactly the same process lies behind the success of momentum investing. Investors tend to underreact to signs that some companies are enjoying improved prospects. This causes share prices to fail to rise sufficiently upon good news, with the result that they rise later - so price rises lead to further rises, giving good returns to momentum investing.

Another example comes from my mum - and, I suspect, many of our parents. Despite her children's efforts to persuade her to move to a more manageable house in a more convenient area, she refuses to consider the idea. This is an example of the endowment effect - our tendency to overvalue things we own merely by virtue of owning them; my mum loves where she lives, even though it seems to others obviously inferior to alternatives.

This endowment effect distorts the housing market, by causing people to take their properties off the market when prices fall below their owners' inflated values, with the result that market liquidity dries up when prices are low. But we also see it in the stock market, in what economists call the disposition effect. We tend to hold onto losing shares in the hope of getting even. This is irrational - because the price you paid for a share doesn't tell us about its future price - and potentially costly because it exposes us to downward momentum effects, the tendency for price falls to lead to further falls.

You might think that the two things I've just described - underreaction and the endowment effect - are different things. But they might not be. Duke University's Dan Ariely - one of the world's leading behavioural economists - says underreaction might be a special case of the endowment effect. When we own an idea, he says, we overvalue it, and so disregard evidence which conflicts with it - with the result that we don't change our ideas sufficiently when the facts change.

There is, though, another reason why we tend to hold onto losing shares - wishful thinking. An experiment by the University of Melbourne's Guy Mayraz showed how easily this arises. He split subjects randomly into two groups - 'bakers', who'd be paid well if the price of wheat fell, and 'farmers', who'd be paid if it rose - and asked them to forecast future wheat prices having looked at charts of recent price moves. He found that 'farmers' guessed that future prices would be higher than 'bakers' guessed, even though both groups had the same information. This warns us that we can easily become over-optimistic about returns on assets merely by virtue of holding them.

And again, this isn't confined to investing. It's all around us. We all overestimate our team's chances of winning a trophy; youngsters appear on the X Factor hoping to become the next Mariah Carey; and older folk write novels in the hope of becoming the next JK Rowling or Martin Amis.

Closely related to wishful thinking is overconfidence; we all believe we're better drivers than average, and we all know a pub quizzer who's perfectly confident in his answers and often perfectly wrong. This isn't wholly a bad thing; we'd have few entrepreneurs, writers or musicians if everyone had a rational opinion of their chances of success. But it can cost us money by tempting us to trade too much or to invest in expensive actively managed funds in the mistaken belief that we can spot the next good stock or fund. (And this is not to mention the huge losses that overconfident bosses can cause by embarking upon catastrophic takeovers such as RBS's of ABN Amro.)

One solution to our tendency to trade too much is simply to have the discipline to stick to a few well-tested rules. Economists at AQR Capital Management have shown that this discipline - more than intellectual ability - is the secret of Warren Buffett's success. He stuck to the principles of buying quality stocks even during the tech bubble when doing so lost money, and so profited hugely when time-honoured principles came back into favour.

And again, it's not just in investing that discipline pays off. Research in recent years has confirmed what Victorian schoolmasters knew - that discipline and hard work, more than natural talent, are necessary for mastering any subject, be it sport, music or academic disciplines. "Experts are always made, not born," says K Anders Ericsson of Florida State University, whose research has been popularised by Malcolm Gladwell as the 10,000 hour rule; it takes 10,000 of hard practice to master any discipline.

There is a simple, and important, point to all this. Financial markets are not (just) separate and distinct fields of behaviour requiring specialist and arcane knowledge which is possessed only by a few pompous men in suits. Instead, the same mechanisms that drive shares - and occasionally cause them to become mispriced - are found in everyday life. You can learn about investing not just by poring over company accounts and listening to boring men, but simply by looking at the often curious behaviour of those around you. It is this that makes stock markets so interesting.