Friday, March 25, 2016

Irrational Investing: A Behavioral Finance Primer

Nicholas Zaiko, CIMA®
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.  

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)