Why Investors Make Poor Decisions

In our initial “Worth Mentioning” note last quarter, we wrote that the intent of this correspondence is to address a single investment topic from a fresh perspective.  As topics go, the headline above would seem a little ambitious for this format, but we’ll use this as a brief introduction to the compelling principles of Behavioral Finance.

The fact that investors often make sub-optimal decisions is hardly a news flash.  What is notable, however, is that these flawed decisions are systematic and often predictable.

Behavioral finance is a burgeoning school of thought that explains how emotion and biases can cloud our judgments and actions.   There are common observable “rules of thumb” (heuristics) that investors rely on to process information that contribute to this irrational behavior.  For investors (lay or professional), understanding the pitfalls and traps can be instructive in avoiding these tendencies and exploiting the market inefficiencies that develop as a result.

Studies from leading researchers on the subject classify “mental shortcuts” used by investors into several key areas:

  • Representativeness – the tendency to predict outcomes based on similarities to past situations (seeing patterns in randomness.) This causes investors to overreact by placing too much weight on new information, i.e. spotting the next Microsoft.
  • Anchoring – when new information runs counter to existing beliefs, investors “anchor” to what they know.  This causes investors to underreact to new data, i.e. a positive earnings surprise is more likely seen as an anomaly than a new trend.
  • Overconfidence – when investors are asked to identify a range of possible outcomes, real outcomes fall outside the range far too often.  The overconfidence of the Nobel laureate founders of Long Term Capital Management hedge fund enabled them to accept great risks, resulting in disaster (1998).

Other behavioral shortcomings include: Frame Dependence – investor’s response affected by how a situation is presented, Hindsight Bias – accurately predicting history, Confirmation Bias – embracing research only when it confirms current thinking, Loss Aversion – pain of loss greater than pleasure from equal gain and Regret – action to avoid pain of feeling responsible for loss.   All these tendencies contribute to decisions that often “feel” right, but in reality, work against long-term success.

Behavioral finance is a nod to reality and a step back from the generally accepted “efficient markets theory” (EMT).   The EMT model, developed in the early sixties, held that the current price of an asset reflected all known information of the collective marketplace, and therefore, was efficiently priced.  However, anomalies in market behavior (crash of 1987, tech bubble) clearly support the view that there are other, less rational, forces at work that impact stock prices.

Recognizing “sentiment-based risk” is the essence of behavioral finance, but it is not a self-contained panacea for successful investing.  The striking failure of some quantitative models in the recent market correction serves as a reminder that even unemotionally driven investment processes are vulnerable when emotion hits high levels of panic and fear.  Still, if the objective of active management is to exploit these inefficiencies, then the investment process should have some means to recognize these natural human tendencies.

The volume of research in recent years validates a growing acceptance of these principles and firms like ours will continue to push the practical application of behavioral finance in managing portfolios.  Richard Thaler, one of the pioneers of this movement, says that behavioral finance, as a distinct way of thinking, “will come to an end when its elements become part and parcel of regular financial analysis.”  That day may be forthcoming, but until then, understanding one’s own cognitive limitations will continue to serve investors well.