Investment Consultant
Bridgebay Financial, Inc.
Much to the chagrin of traditional economists and
financial academics, the pristine mathematical models used to describe the
movements in asset markets falls short of accurately representing the real
world. The foundation of classic
economic theory relies on the premise that all investors and market
participants act in their own self interest and are rational at all times. Yet in practice, we see that markets do not
always work in a rational way. Markets
may act irrationally because ultimately, markets are made up of people who are
motivated by emotions.
Rather than attempt to predict or quantify investor
behavior, behavioral finance seeks to at least identify and categorize the
myriad of human responses to investment related stimuli. Most frustrating to traditional financial
academics is the phenomena of the same stimuli eliciting different and
sometimes contradictory responses from different investors, making reliable
predictions of human behavior all but impossible. Behavioral finance endeavors to acknowledge
the overwhelming and unpredictable impact of investor behavior and identify
patterns that may explain the discrepancies between the financial industry's
rational-based models and the irrational nature of the real world.
Overconfidence
Studies have conclusively demonstrated that people
in aggregate are overwhelmingly overconfident.
A simple experiment will reveal the truth of this statement. Ask anyone if they consider themselves to be
better or worse than the average driver.
Without hesitation, the majority of people will respond that they are in
fact better. Obviously, this cannot be
true, by definition, half must be better and half must be worse.
Overconfidence is most noticeably manifested in the
realm of investment behavior when we look at the trading activity of different
investors. Overly confident investors
tend to have higher turnover with more frequent trading. A study published in the Journal of
Finance1 in April 2000 demonstrated that though the gross
returns of accounts with high turnover were similar to those of accounts with
very little turnover, the net returns for high turnover accounts were
significantly lower than their low turnover counterparts. Close to 30% of the net return was lost to
the transaction costs of the high turnover portfolios. Overly confident investors think they can
beat the market more frequently which results in higher trading volume and
ultimately lower net returns.
Gender and marital status plays a major factor in
an investor's individual risk tolerances.
A February 2001 study published in the Quarterly Journal of Economics2
examined the investment results of single and married men and women and
revealed some interesting patterns regarding risk profiles. Single men were by far the most aggressive
with their investments, generating the highest average returns accompanied by
the highest volatility. The next
riskiest investors were married men, followed by married woman, then single
women. More overconfidence leads to
taking on higher levels of risk.
Regret and Pride
Psychologists have identified the feeling of regret
as one of the most powerfully uncomfortable emotions a person can
experience. Throughout history, people
have gone to extraordinary lengths to avoid this particular emotion. And so it is with investing. The typical behavior most commonly associated
with regret avoidance involves the tendency of investors to sell their winners
and hold on to their losers. Realizing
gains from the sale of a successful stock holding is an enjoyable experience
whereas realizing a loss and admitting defeat by selling at a loss is a painful
one. This type of behavior leads to
portfolios overweighted with underperforming assets. Harvesting gains at the expense of harvesting
losses will also generate increased taxes on top of the unrealized losses still
trapped within the portfolio. A 2010
study published in The Psychology of Investing3, verified
that after a significant rally in any particular stock, abnormal trade volume
increases. Similarly immediately after a stock has fallen
significantly, trade volume decreases dramatically.
Regret avoidance is also at the root of a very
common behavior involving the concept of sunk cost. Rather than admitting defeat and enduring the
pain of selling a declining security before losses get even larger, many
investors will tend to double down, throwing good money after bad.
Past Performance Risk Taking
Another common fallacy is the investor belief that
past success or failure will somehow influence the odds of success or failure
in the future. While it is certainly
true that good managers can add value through active security selection and
tactical allocations, the probability of future success in any one security or
investment depends on its future prospects and may be is independent of its
past performance. This phenomena is also
described as the "gambler's fallacy".
Simply put, if an investor experiences success early on, they tend to
increase their risk tolerance and make more aggressive trades.
Another component of this behavior is the idea of
using house money; taking on more risk
with the winnings of earlier success.
Alternatively, investors who experience losses early on typically react
in one of two contradictory ways. Some
investors reduce their risk tolerance as a result of early losses, the
"snakebite effect", while others increase their risk- taking in an
effort to make up for lost ground. In a
purely rational world, a methodical and static risk tolerance should drive the
investment process. Yet in reality we
see that risk tolerance is highly dependent upon the individual's recent
investment experience outcome and we find that it is anything but static. Reality is perception for investors and their
view of risk changes from day to day and year to year.
1 Brad Barber and Terrance Odean, Journal
of Finance, "Trading is Hazardous to Your Health" (April 2000,
page 775)
2 Brad Barber and Terrance Odean, Quarterly
Journal of Economics (February 2001)
3 John R. Norsinger, The Psychology
of Investing, Prentice Hall, Upper Saddle River, New Jersey (2010)
