Although finance may not be everyone’s favorite literary topic, over the past several years, a new emphasis on Behavioral Finance and Behavioral Economics have gained significant popularity in the non-fiction press, through books such as Freakonomics, Nudge, and Thinking, Fast and Slow. Whereas, conventional financial theory operates on the assumption that, on average, investors are rational actors who make optimal investment decisions based on their beliefs and preferences, behavioral experiments examine how people actually behave, and the implications of that behavior for our concepts of the market.
The traditional view in academic finance of investors as rational actors, combined with a relatively free flow of information, are the foundation of the Efficient Markets Hypothesis (EMH)1 which states that asset prices instantaneously incorporate and reflect all new information. If the EMH is strictly accurate, then active investment management cannot add value, since it will be impossible for anyone to outperform markets as a whole, which are reflected by market indices. While the EMH is popular in many academic circles, the school of thought known as behavioral finance holds that investors as a whole are not rational, but are in fact irrational in predictable manners. This article will discuss several key tenets of behavioral finance, as well as the implications for investors.
Suppose an investor purchases a stock at the price of $10 per share. Over the next six months, that stock experiences tremendous growth, reaching a price of $30 per share. In the second half of the year, the stock loses value, ending the year at $25. The proper way to evaluate this investment at the end of the year is to look at the gain that could be realized if the stock was sold at that point. This would be a gain of $15 (or 150%) per share, which would be a phenomenal one-year return. However, many investors would instead consider the final price relative to the peak price, perceiving a loss of $5 per share (or a return of -17%). This tendency to latch on to a particular price or value is known as anchoring, and can result in investors using inappropriate metrics to evaluate the performance of their portfolio. Another effect of this cognitive bias can be to cause the investor to believe that the stock is now under priced, because the current price of $25 is lower than the earlier price of $30. While this may or may not be the case, the stock should be evaluated on the fundamental properties of the asset, not simply the relative price across time.
Another common behavioral trait exhibited by investors is confirmation bias, where investors only pay attention to information that confirms their previously held beliefs, and ignore anything contradictory. For example, if an investor was interested in stock XYZ, they might be more likely to notice good news pertaining to that stock, while not paying much attention to news that might imply a negative outlook for XYZ. A result of this selective information gathering is to give the investor unrealistic expectations for the performance of their investment. A similar trait displayed by many investors is a tendency to believe that past market events or asset performance were predictable at the time. Hindsight bias, as this type of misperception is known, causes fundamentally unpredictable occurrences to appear to have been obvious. A fairly widespread example of this is the 2008 Financial Crisis. Many market participants claim that a financial meltdown was apparent before it actually happened, but if this were actually the case they would have invested in a much different manner and would have stood to realize outstanding relative performance. With the notable exception of a handful of managers, portfolios were devastated in 2008-9, so it seems fairly unlikely that many people accurately foresaw an oncoming market calamity in 2008.
Another bias is representativeness, or the belief that realized events are representative of reality. The most common place this is manifested is investors chasing returns. Despite mountains of evidence (and mandatory disclosures) that past performance does not necessarily reflect future results, many investors use the previous several years of performance as the primary tool in selecting investments. The implicit belief is that because things were a particular way in the past (i.e., recent asset performance was a certain level) that this will continue to be the case in the future. Believing that recent events are representative of the future, along with the tendency of people to “follow the herd” in making decisions is a primary causal factor in the creation of asset bubbles like technology stocks in the late 1990s or real estate in the mid-2000s.
Behavioral biases are a fact of life. We are all subject to some or several of these traits to some degree; the important thing is to recognize these tendencies, and avoid letting them adversely affect your investment results. We recommend creating an explicit investment strategy, preferably in writing for future reference, and sticking to that strategy barring any fundamental changes to your investment situation. Your investment strategy should allow you to articulate every investment decision you make. Evaluating options in the context of your pre-established investment policy should reduce the chances of making an emotional decision potentially damaging to your investment goals. At Empirical we have an Investment Policy Statement (IPS) document that outlines in detail our investment strategy and the reasoning behind each decision we make. This IPS is always available for our clients, so please speak with your advisor if you would like a copy.
