“Wouldn’t economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?”
― Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions
Conventional Finance theory has long assumed that Investors/Consumers etc. are rational, risk-neutral wealth maximisers, but the experience of the Dot Com bubble, the mortgage bubble and so on has led many to question this premise. Thus was born the field of Behavioral Finance, which posited that people make irrational decisions in a large number of situations, partly due to hard-wired psychological impulses that we find difficult to control.
This week we tweeted a list of some of the more commonplace cognitive errors individuals make, primarily with reference to Investment, but in other walks of life too. Dalbar do yearly analyses that suggest what investors get in returns is far below that of the funds they invest in, let alone benchmark average returns, mostly due to illogical or overly emotional thinking. We shall examine some of them to see what (if anything) can be done to eradicate them. Some of the more pernicious examples are highlighted below.
1) Anchoring Bias:
How often have we seen “Sale” prices, which mention how far they have been reduced by? This gives us the impression that we have “saved ” money, but only compared to the stated previous price. But was that the “real” price? If the shop/travel agent etc. can get you to believe this, it enhances the feeling of saving money, prompting us to buy. Similarly, in long-term investment trends, (e.g. the Internet bubble), we got so used to high (and ever rising prices), that it became difficult to imagine lower prices ever occurring. But occur they did, and those who fixated (or Anchored), on then-current valuations as being the norm, were cruelly disillusioned. (Group think often plays a part here too. If everyone believes in it, why shouldn’t we?). Today, Bond yields are scraping along the floor, and no-one can remember, let alone imagine, 7% Gilt or Treasury yields. That one can’t imagine it doesn’t mean it can’t happen…
2) Clustering Illusion:
Numerology should be the subject of ridicule, but many believe in it. People tend to see what they want to, and the more they “see” the more they believe. Gambling is a common medium for seeing “patterns” – no matter how many times Heads comes up, the odds are STILL 50:50 on the next coin toss. Investment experts often foretell of doom using charts as their guide, and Investors are often frightened or persuaded to act on their “advice” (feeding into #’s 5, 7, 9, 15 and 17 too). For an example of how well this worked out in 2016, see here. It is also linked to the tendency (after the event), to assume that such an outcome was inevitable – few, if any predicted the market collapse after the Mortgage bubble of 2006-07, but many AFTERWARDS said it was inevitable (just not until 4 years or so later).
3) Outcome Bias:
This is the belief that the result is more important than the process. Walking across a motorway blindfolded is never a good idea, even if one makes it to the other side unscathed. Thus, one hears investors more concerned about actual losses, than the reality that losses will always happen from time to time. Diversification means some declines in parts of a portfolio are going to happen – if bonds and stocks are negatively correlated, they will move in opposite directions much of the time, but that does not negate the value of having both. The process of diversifying ensures that the end (a low volatility return) is achieved with as little risk as possible. But there will be times when it doesn’t perform – this is a feature, not a bug of the process. But if all one focuses on is results, it is likely that one will be constantly chasing performance, leading to large portfolio turnover, and almost certain failure.
This will take a variety of forms, but in general terms, it is the unsubstantiated belief in our own abilities to predict, guess or just know things. (Take this test to see if you are overconfident – I got 5 right!). As it happens, experts are the worst offenders (the rest of use seem to know our limitations better), which explains their baleful predictive performance. We all think we know more than we do, which is why we get lost whilst driving in a new place and have to be pried away from the Karaoke machine of an evening. Overconfidence led to the downfall of Custer and many other Military leaders, as well as the individual investor, who thinks that they know more about a company’s share just because they work there. The extent of the damage varies, but it is rarely good; it may just be opportunity costs, but it can be much worse.
You may recognise yourself some of the 20 traits on the list – I certainly do. As humans, we are ALL vulnerable to these failings; knowing about them won’t necessarily ensure we avoid them, but if we know about them, we may better prepare for when they arrive. The ultimate cost of these errors may be hidden, but that doesn’t mean they aren’t there. Investing is an area where it can cost the most to practice these behaviours – so it makes sense to be aware of them, in oneself as well as others.
Forewarned is forearmed!