Investors have seen the enemy and it is ourselves
The insidious influence of emotions and cognitive bias on investment performance is not limited to individual investors. Photo by Andrew Kelly/Reuters Behavioural finance is the study of the influence that psychology has on investors. Its central theme is that investors are influenced by cognitive biases and are not always rational, which leads to self-defeating behaviours and suboptimal results.
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“The fact that people are fallible is your biggest enduring advantage in the accumulation of greater wealth,” behavioural finance expert Daniel Crosby states in his book, The Laws of Wealth: Psychology and the Secret to Investing Success. “The fact that you are just as fallible is the biggest impediment to that very same goal.”
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Let’s take a look at some of the more common behavioural pitfalls that investors would be well-advised to avoid when making decisions.
Confirmation bias This is the tendency of people to pay close attention to information that confirms their beliefs and ignore information that contradicts it. Our natural tendency is to listen to people who agree with us because it feels good to hear our opinions reflected to us. We first construct hypotheses, and then subsequently look for information that supports them.
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The pain of loss is (myopically) larger than the pleasure of gains It is commonplace for investors to have an unbalanced desire to avoid losses at the expense of foregoing commensurate or greater gains.
People often refrain from selling losing positions in hopes of making their money back, thereby allowing run-of-the-mill losses to metastasize into there-goes-my-house losses. Many investors also get anxious to lock in profits and sell winning positions prematurely, thereby limiting their gains. In tandem, these biases exacerbate losses and curtail profits, which is not a successful formula for long-term performance.
Fear of missing out (FOMO) Feelings of anxiety or insecurity over the possibility of missing out on an event or opportunity tend to be strongest when the market is irrationally exuberant.
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For example, the Nasdaq from 1996 to 2000 exploded to 4,131 points from 1,058. Many companies in the index had little or no earnings, yet their stock prices were increasing at a parabolic rate. Investors feared that if they didn’t get in, they would miss out. The dotcom bubble then burst, and trillions of dollars of investor wealth vanished as the Nasdaq plunged to less than 2,000 points by the end of 2001.
“Nothing sedates rationality like large doses of effortless money,” Warren Buffett has said. “After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem: They are dancing in a room in which the clocks have no hands.”
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The bandwagon effect Many investors gain comfort when doing something simply because many others are doing it, which can lead to severe losses. This has historically resulted in speculative bubbles in which the crowd joins hands, runs off the cliff together and subsequently commiserates over extreme losses.
Anchoring/framing bias This is the tendency to rely too heavily on, or anchor to, a particular reference point or piece of information when making a decision.
People often base their investment decisions on where current prices stand relative to their histories. Unfortunately, where a stock’s price has been in the past often offers little information on how it will perform going forward. A stock’s historical high price can make its current price look cheap, regardless of the company’s actual value. Neither BlackBerry Ltd.’s nor Nortel Networks Corp.’s high-water marks proved effective in predicting their fates.
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Inertia bias People have an aversion to change. Investors can become complacent, deluding themselves into believing that existing conditions will continue indefinitely. This mindset renders them defenceless when circumstances change, exposing them to avoidable losses.
Investment research firm Dalbar Inc. has since 1984 published an annual report called Quantitative Analysis of Investor Behavior (QAIB). Time and again, it clearly demonstrates that people are often their own worst enemies when it comes to investing.
In the 10 years ending December 2019, the average United States equity fund had an annualized return of 13.6 per cent, while the average investor in these funds reaped an annualized return of 11.1 per cent. The difference was primarily attributable to emotionally driven decisions to invest and divest, which proves the adage that the public always buys the most at the top and buys the least at the bottom.
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The insidious influence of emotions and cognitive bias on investment performance is not limited to individual investors, either.
A 2019 research paper, Are Professional Investors Prone to Behavioural Biases? Evidence from Mutual Fund Managers, suggests professional fund managers also make behavioural mistakes. After analyzing mutual fund data from 2006 through 2018, the author’s findings “suggest that professional investors suffer from behavioural biases, that their market outlook affects their risk taking and asset allocation, and that fund managers’ optimism is detrimental to fund investors.”
If we’re going to be smart humans, we must learn to be humble in situations where our intuitive judgment simply is not as good as rules-based processes based on statistical analysis. Although there can never be certainty when it comes to financial markets, I am confident that data, math and a logical decision-making process lead to superior results over the long term.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.