Lessons from the Fascinating New Field of Behavioral Finance
We would all like to be as cool and calculating as Warren Buffet in managing our portfolios. Unfortunately, we probably can’t be. In fact, Mr. Buffet’s mentor, the great investor Benjamin Graham once said,
“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
Often, as investors, we are overcome by emotion and other traits which subtly and often imperceptibly affect our ability to make good decisions. The field of behavioral finance, which ironically grew up as an academic discipline alongside modern portfolio theory (MPT), which assumes that people are always rational. Behavioral finance identifies a laundry list of biases, or behavioral mistakes, we all tend to make in our financial decision-making, due to “human nature”—especially when we have to make a large number of decisions. Behavioral finance received its own Nobel Prize in 2002, with the award going to Princeton Professor Daniel Kahneman for his groundbreaking work in the field.
Here are some of these decidedly human traits, which have been identified and thoroughly researched:
- Mental Accounting: treating pools of money, which are fungible, as different depending upon the source, such as whether it is earned or received as a gift.
- Heuristics: guidelines we use to simplify decision making, which are sometimes useful,
but frequently lead to bad decisions. An example would be the “rule” to keep 100 minus your age as a stock allocation
- Risk and Loss Aversion: our tendency to view the pain of a loss as greater than the advantages of an equal amount of gain. This frequently causes investors to hang on to their losers and sell their winners.
- The Sunk Cost Fallacy: a framing bias, similar to loss aversion, by which we analyze the future prospects of an opportunity by how much we have already invested in it, sometimes encouraging us to “throw good money after bad.”
- Over-Choice Paralysis: the inability to make decisions because of the existence of a confounding number of choices, such as deciding which handful of the nearly 10,000 available mutual funds are appropriate for your portfolio.
- Status Quo Bias or “Endowment Effect”: the psychological resistance to change, particularly when it involves parting with something you already own. This often compels investors who have inherited concentrated positions in shares which have been in the family for many years to remain dangerously undiversified.
- Recency Bias: one of innumerable innumeracy (mathematical) mistakes even the smartest people tend to make in miscalculating the odds of something based upon a recent small sample rather than a sufficiently large one. For example, one might believe that a fund manager has above average skill based upon a few years of out-performance, which is just as likely, statistically, to be a matter of luck. Likewise, tending to like investments that have done well in the recent past, when in fact the highest future returns probably lie in investments that are currently out of favor falls into this category.
- Anchoring and Confirmation Bias: relying on facts and figures that should have no bearing on your decision making and giving to much weight to data that confirm your initial
impressions to the exclusion of more objective information. A classic example of anchoring is basing your view of the current value of a stock on the basis of what it may have sold for at some time in the past, e.g., “if you liked it at $100, you’ll love it at $50.”
- Overconfidence: people, by and large, substantially overestimate their investing acumen and ability, in large part because they improperly (viz. “The Beardstown Ladies”) or even simply fail to measure their performance. Despite the mathematical certainty that investing is a zero sum game, still over 90% of equity investments are actively managed in an attempt to beat the market. Overconfidence is doubly pernicious because correcting or making up for it requires us to be skeptical of our abilities, a process which overconfidence
is likely to inhibit.
These apparently hard-wired tendencies can be extremely difficult to overcome. Unfortunately, it can sometimes seem like going on and staying on a diet or exercise program. The idea, however, is not to lose our humanity but to recognize and manage it. The only reliable antidote to these annoying peccadilloes is to develop a strategy which 1) makes the really big, important decisions at the outset and 2) establishes in advance the decision-making criteria for subsequent decisions; and then to have the discipline to stick to your strategy unless your fundamental goals and attitudes change.
For example, if your time horizon is in fact long term, think and act long term. It’s also best to see your portfolio as what it is: a means to a series of ends—your goals! Managing it is not designed to provide excitement or satisfaction or be a measure of your machismo. Success demands that you plan well and be confident in your plan so you don’t react to the markets. The markets are chaotic. Enjoy the chaos. Keep your eye on the big ball (your portfolio as a whole) and not on all the little balls (the individual components.)