What is Behavioral Finance?
“Two things are infinite: the universe and human stupidity; and I’m not sure about the universe.” – Albert Einstein
Most capital market theories are predicated on a very key assumption – the average market participant is rational and seeks to maximize their wealth. The problem with this assumption is it does not hold true. Rational analysis is well within the understanding of most investors, however during times of intense market volatility many investors panic, making irrational decisions based on psychological factors. Under pressure, our instincts often distort our reasoning and tend to push us to make decisions that will reduce our anxiety.
DALBAR does an annual study of the performance of individual investors versus the market. In the 20 years ended 2012 the average stock mutual fund investor averaged only a 4.25% annual return even though the S&P 500 returned 8.21% annually over the same period. What is the average investor doing so horribly wrong to cause such drastic underperformance? The field of behavioral finance seeks to explain how human behavior impacts investment results. Having a good knowledge of the psychological factors that play a role in the investment decision making process can help us to not only better understand the way our clients think, but also ourselves.
“The investor’s chief problem – and even his worst enemy – is likely to be himself” – Benjamin Graham
According to Professor Daniel Kahneman of Princeton University, who was awarded a Nobel Prize in 2002 for his contributions to behavioral economics, each of us behave as if we have an “intuitive” mind, which forms rapid judgments with no conscious input. We also have a “reflective” mind, which is slow, analytical and requires a conscious effort. Our minds are naturally lazy and prefer to use the intuitive way of thinking. Professor Kahneman and other behavioral finance researchers have identified many circumstances in which the intuitive mind leads people to make money-related mistakes.
Heuristic refers to the process by which people learn, discover, or solve problems for themselves. This is typically done by trial and error and often leads to rules of thumb, or a simplification of things that are poorly understood. Behavioral finance studies these rules of thumb and the systematic errors that can result from following them.
Availability Heuristic – A rule based on the degree to which information is readily available. Research by Professor Shlomo Benartzi of the UCLA Anderson School of Management found “Most people simply don’t have the time or expertise to find fairly valued stocks or under-valued stocks. As a substitute for appropriate analysis, many people unconsciously fall back on a simple rule of thumb, or heuristic; what stocks are in the news? Buy them. Apparently, it matters not at all why a company happens to be in the news – the launch of a new product, large one-day moves on the market (up or down), even a scandal involving the CEO” (Barber and Odean, 2008).
Representativeness – A term used for our reliance on stereotypes. Stereotyping is considered a bad word in our culture, but the reality is it’s a natural way that our minds work and we all do it. Our intuitive mind holds in it an idea of what a normal representation of a category should be so as to operate efficiently. We have a stereotype of what a car engine sounds like, what a tree looks like, and what a dairy farm smells like so we can identify things immediately. People who say they don’t stereotype either misunderstand what it means or they are truly proclaiming proudly they have an inefficient brain. An example of this in investing can be found in the belief that an investment’s good performance in the past is representative of how it will perform in the future. Despite the ubiquitous investment disclosure “past performance is no guarantee of future results,” the majority of investors typically balk at the idea of selling one of their best performing funds or buying one that has performed poorly. Investors become overly pessimistic about past losers and overly optimistic about past winners. This creates situations where prices can decouple from the underlying fundamentals – sometimes for prolonged periods – but ultimately mispricings are not permanent.
“Economists are very good at telling you what has just happened!” – James Montier
Hindsight Bias – Representativeness and the availability heuristic are tied to one of the most common behaviors investors exhibit – hindsight bias. Hindsight bias is the propensity to see events that have already occurred as being more predictable than they actually were. For example, if we look back at the real estate market crash we experienced a few years ago, for most it is now very easy to see there was a bubble. Many make the claim today they saw it coming. But how many people accurately predicted it beforehand and actually sold their homes or shorted bank stocks in anticipation?
Overconfidence – Overconfidence, technically speaking, is when people are surprised more often than they expect to be. Overconfident investors tend to set narrow confidence intervals, which results in more unexpected outcomes outside of the expected range. Investors who suffer from overconfidence tend to have an overly optimistic assessment of their control of a situation. They believe their information is correct, and they have a superior ability to interpret that information to make better decisions when in reality they are almost always at an informational disadvantage. In investing this typically leads to increased trading activity, and higher trading activity has been shown to lead to below average performance. A study by Brad Barber and Terrance Odean from the Graduate School of Business at the University of California found that the average individual investor turned over more than 75% of their portfolio each year. Untimely changes and transactions costs associated with this reduced performance by 3.7% per year. Investors who traded the most (200% turnover) reduced performance by 10.3% per year. So on average, the more you trade the lower your return. As men are more susceptible to overconfidence, it also means that female investors tend to outperform their male counterparts. Studies have shown that men trade about 45% more than woman do. That’s of note considering the investment industry is dominated by males (only 19% of global CFA charterholders are women).
“Your money is like soap. The more you handle it, the less you’ll have.” – Gene Fama
Anchoring-and-Adjustment – Analysts use information available to them to form beliefs about an investment. However, when new information becomes available they tend to anchor to their original estimates and not adjust accordingly, under-reacting to both positive and negative news.
Aversion to Ambiguity – People are comfortable with what they know, and unfamiliar situations tend to lead to the emotion of fear. This likely explains why U.S. investors have an overweight position in U.S. stocks (Home Country Bias) or why doctors tend to overweight healthcare stocks (Familiarity Bias). Familiarity is also why investors tend to overweight the stocks of the companies in which they work because they know the company well. This can have a devastating impact on someone whose company goes bankrupt, causing them to lose both their job and a significant portion of their wealth at the same time.
Frame dependence means that the form in which a problem is described has an impact on behavior.
Mental Accounting – This approach relates to an investor’s attempt to code, categorize or evaluate potential economic outcomes. An example would be an investor who only spent the income generated from their investments so as to “not dip into principal.” They are mentally accounting for the different forms of return – current income and capital appreciation – instead of looking at the total return. This isn’t a problem so long as the investor’s income needs can be met with a well-diversified portfolio and asset mix that meets their long-term objectives and tolerance for risk. But if that’s not the case, an investor may fall prey to their mental accounting rule and restructure their portfolio to generate more current income instead of taking a total return approach. This might mean selling stocks in order to increase their allocation to bonds, adding a small amount of yield but greatly reducing the potential for growth in the portfolio and therefore increasing the risk of outliving one’s assets. Or they may meet that income goal by increasing risk beyond what is prudent by loading up on junk bonds, preferred stocks, or unsustainably-high dividend-paying stocks. This exposes them to more downside risk. Many investors refuse to sell any investment for a loss. They often mentally account for these as not real but rather “paper losses” because they haven’t locked them in yet. Make no mistake about it, though, there is no such thing as a “paper loss”. This is just another form of mental accounting for investors who can’t cope with the fact they lost money. On the flipside there is no such thing as playing with house money.
Loss Aversion – Investors have been found to have much stronger feelings of regret towards losses than joy for equivalent gains. In fact, Daniel Kahneman and Amos Tversky found in their research that a loss has as much as two and a half times the emotional impact of a gain of the same magnitude. The negative is always more powerful than the positive. Loss aversion has a profound impact on portfolio returns. People are not uniform in their tolerance for risk; they are risk averse when it comes to gains and risk seeking when it comes to losses. Many investors refuse to sell any investment for a loss, because doing so will mean giving up the hope they might get back to even. At times this means riding a stock all the way to the bottom.
“A single cockroach will completely wreck the appeal of a bowl of cherries, but a single cherry will do nothing at all to improve a bowl of cockroaches” – Paul Rozin
Myopic Loss Aversion – This pertains to an investor’s reluctance to hold stocks because they are evaluating their decisions over excessively short time periods. In other words, they are narrowly framing the outcome of their investment decisions over days, weeks, and months instead of broadly framing it over their time horizon which is years and decades. This behavioral trait can cause investors to lose sight of their long-term goals in times of heightened market volatility and tempt them to stray from their investment plan until things calm down. It is impossible to predict the day-to-day movements of the markets, and investing to accomplish long-term goals involves weathering a number of down markets. Investors who attempt to sit out the rough patches of the market inevitably miss out on opportunities. While it is difficult to endure the downside of the market, the ability to predict those downturns is also very difficult. Those that do move to the sidelines are then faced with the equally difficult challenge of determining when to move back into the market after the turmoil has passed. In times of stress our emotional time horizon shortens and distorts our risk premium, but the probability of losing money in the equity market becomes very low over periods greater than six years. Even with the financial crisis of 2008 and 2009, the S&P 500 surpassed the October 2007 peak in less than six years. In fact, we have since hit all-time highs despite experiencing the most emotionally trying investing period of our lifetimes.
At EmerealdSpark we believe understanding these common behavioral mistakes and learning to overcome them can lead to enhanced investment returns. The truth is you can’t rewire the way your brain works, but we can be aware of how it does work and try to mitigate the damage it can have on your investments.