Why we are lousy investors
SKK Graduate School of Business dean
We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.
In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.
We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.
Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.
There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors hate to admit mistakes which include stock market losses, so there is also regret aversion.
Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.
Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.
When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s why we take credit for our successes and blame others for our failures.
Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.
People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.
Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.
Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.