In March of 2016, and as published in our book Thinking About Investing, we added to our behavioral finance principles by discussing Richard Thaler’s book, Misbehaving: The Making of Behavioral Economics, and articles in The New York Times “Your Money” section from March 27, 2016.
The point of the discussion was to present some of the personality traits that can become obstacles to successful long-term investing:
“Changing how people think about the money they save for retirement is a central tenet of a movement based on behavioral finance, the approach to economics that aims to understand how average people, not rational economists, make financial decisions. After all, it’s the way people behave around money that tends to derail their plans, not a lack of knowledge about what they need to do if they want to retire comfortably.”
The article, written by Paul Sullivan, discusses ways behavioral finance helps people save more for retirement and also helps people “limit their investment choices, so they would need to opt out of a broadly diversified portfolio, which is the portfolio most likely to produce the best returns over time.”
The primary article in The New York Times “Your Money” section, “Why We Think We’re Better Investors Than We Are,” was written by Gary Belsky. The article starts by explaining why Behavioral Finance focuses so many of its studies on the investment markets – because they “provide unusually robust data sets for analyzing ‘judgment under uncertainty,’ … how people make choices when resources are at stake and the outcome is unknown.” The article then comments on the “sunk cost fallacy,” which causes investors to focus on their original cost, not wanting to sell at a loss, representing “a nonconscious desire to justify their earlier decision.” This idea feeds into the “key tenet of ‘loss aversion,’ which tells us that humans typically respond to the loss of resources – be it time, emotion, material goods or their proxy, i.e., money – more strongly than they react to a similar gain.
The article continues:
“Despite the spectacular growth of index funds – passive investment vehicles that track market averages and minimize transaction costs – millions of amateur investors continue to actively buy and sell securities regularly. This despite overwhelming evidence that even professional investors are no more likely to beat the markets than a monkey throwing darts at security listings. Money managers, at least, are paid to make investment bets. But why do amateurs believe they can outperform the professionals – or even identify those pros who will outperform?”
(Performance of mutual funds cannot be predicted with any greater degree of accuracy than individual stocks or bonds).
Many biases and cognitive errors contribute to this costly behavior, but a few deserve mention.
- Overconfidence: “The tendency to overrate our abilities, knowledge and skill, at whatever level we place them … There is a disconnect between actual and perceived financial sophistication, evidence of how widespread the overconfidence bias is.”
- Optimism bias: “Helps explain why many investors believe they can outperform the market.”
- Hindsight bias: “The tendency to rewrite our own history to make ourselves look good … People consistently misremember their forecasts, in ways that make them look smarter.”
- Attribution bias: “When remembering our failures, we remember them in a way that neutralizes their ability to inhibit our present-day decisions. When events unfold that confirm our thoughts or deeds, we attribute the happy outcome to our skills, knowledge, or intuition. But when life proves our actions or beliefs to have been wrong, we blame outside causes over which we have no control.”
- Confirmation bias: “Giving too much weight to information that supports existing beliefs and discount that which does not … Once one entertains the idea that this seems like a good investment, the processing of relevant information narrows considerably – and in a direction that leads to over confidence.”
The final pertinent article in the “Your Money” section was written by University of Chicago Professor John List. The general point made by Professor List is that, because of loss aversion, people underinvest in the stock market. They look at their investments too frequently, and when they see declines, they sell their stock positions in order to avoid further declines. This behavior occurs even though people are aware of the long-term outperformance of stocks:
“Market research shows that when your horizon is not today, not next week, but way in the future, the most profitable strategy is to invest more heavily in riskier assets – stocks – than people are prone to do. So why don’t people invest more in stocks? … Because people are loss averse … keenly more aware of losses than comparable gains … Those who evaluate their investments frequently, see lower returns on their risky assets like stocks … So what can be done? Not paying too much attention to your portfolio is a good first step.”
More specifically, List’s advice – which he says he follows – is to look at one’s portfolio no more than once every three to six months.
The Thaler book presents all the behavioral finance ideas and their chronological development. We have presented a few highlights that relate specifically to investing.
On investing for the long term:
“The equity premium is defined as the difference in returns between equities (stocks) and some risk-free assets such as short-term government bonds … With a 6% edge in returns, over long periods of time such as 20 or 30 years, the chance of stocks doing worse than bonds is small … (But) the more often people look at their portfolios, the less willing they are to take on risk, because if you look more often, you will see more losses … Defined as myopic loss aversion, those who saw their results more often were more cautious … So the equity premium, the required rate of return on stocks, is so high because investors look at their portfolios too often.”
But in an important footnote, Thaler comments that “this is not to say stocks always go up … they quite recently fell 50%, which is why the policy of decreasing the percentage of stocks in your portfolio as you get older makes sense.”
In a chapter devoted primarily to John Maynard Keynes, he quotes Keynes as follows:
“Day to day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.” – John Maynard Keynes
Thaler writes:
“Keynes was also skeptical that professional money managers would serve the role of smart money, but rather they were more likely to ride a wave of irrational exuberance than to fight it … as it is risky to be a contrarian … and that professional money managers were playing an intricate guessing game, similar to their judging a beauty contest, where the winning judge is the person who picks the faces of those who most of the other judges picked as the prettiest, rather than the faces that he (the judge) thinks are the prettiest.”
In another chapter, Thaler writes:
“When prices diverge strongly from historical levels (our note: that is, long-term average valuation measures such as price/earnings ratios), in either direction, there is some predictive value in these signals. And the further prices diverge from historic levels, the more seriously the signals should be taken. Investors should be wary of putting money into markets that are showing signs of being overheated, but also should not expect to be able to get rich by successfully timing the market. It is much easier to detect that we may be in a bubble than it is to say when it will pop, and investors who attempt to make money by timing market turns are rarely successful.”
Finally, in our extensive experience with individual investors, we would add one more item to the list of behaviors that cause problems: the financial media’s emphasis on day-to-day activity, which turns many people into short-term investors, with the negative outcomes observed by the behavioral finance group. When the short-term results of financial markets are turned into a sports event, or a casino, as they are often reported on by the media, it becomes difficult for even the most disciplined of investors to ignore the “noise” and focus on their long-term objectives. At Park Piedmont, we view overcoming this challenge as a major priority.