Modern portfolio theory assumes that we are rational investors and invest only in efficient and optimal portfolios that provide the maximum return for minimum risk. The truth (as posited by Behavioural Economists) is that we far from rational and are subject to a myriad of psychological influences and behaviours that prevent us from not only making optimal investment or business decisions, but can in some cases turn us into morons. We buy and hold too long or buy and sell too quickly; we refuse to accept losses assuming that we will recover our money or we sell losing investments way too soon; we are overconfident about our own abilities or place too much trust in “experts”; we maintain the status quo and do nothing or we change things too frequently. The dichotomies of investing behaviour are numerous and fascinating and have lead to creation of field of study referred to as Behavioural Ecomomics. Some of these behaviours are discussed below:
Investors tend to make judgements based on stereotypes, which often leads them be too optimistic about winners and too pessimistic about losers. The use of stereotypes is more pervasive than we think, as it helps us to make decisions in the face of information overload. This, however, can lead to bad business decisions. It is simply not true that all purple people are excellent accountants.
Overconfidence, i.e. thinking that you are smarter than everybody else (even though you are) can be detrimental to your portfolio and business. Hubris and arrogance have led to the downfall of many successful business owners and investors (although Donald Trump apparently continues to thrive). Not all of us can be experts in everything.
Over Optimism/Irrational Exuberance:
Thinking that the stock market is going to continue to rise or that your business is going to thrive in the absence of profits and positive cash flows can be foolhardy. The lessons of dot com bubble still loom large with many investors as they watched their investment portfolios, and their businesses (pets.com), melt away.
Anchoring and Adjustment:
This refers to the behaviour where people tend to place too much stock in their first impressions and do not react appropriately to new information. This has bitten many investors and business owners in the ass. I imagine Bernard Madoff made a great first impression as do many interview candidates. I fell victim to this behaviour when I hired someone who came off as being fantastic, and turned out to be, possibly, the worst employee ever. I should have taken action sooner, however it was hard to let go of my first impression and admit that I was so wrong.
Aversion to Ambiguity
Investors like to invest in, and do business, with businesses that they know. One of the most common and most egregious mistakes is to invest too heavily in your employer, as employees at GM discovered in 2008, when the stock was delisted. Poor stock performance is often an indication of trouble within the organization. Worst case scenario you lose your retirement savings and your job at the same time. Business people, similarly, tend to have a hard time letting go of suppliers, employees etc. that are performing poorly as it can easier to deal with the “devil you know”
As we tend to experience losses more intensely than gains, we engage in behaviours to avoid feeling this pain. We might not sell an investment, despite deterioration in fundamentals in the same way that we might not phase out a losing product line in the hopes that there will be a turnaround. However, sometimes, it is time to cut your losses.
People impose limits on themselves that make no sense. For example you might have a stop loss order on equities that fall more than 5%. Similarly, you might not hire someone because they failed to answer one question to your satisfaction. In both cases, the right decision requires a slightly more reasoned and holistic evaluation.
The pain of loss combined with the pain of being responsible for the decision that caused the loss leads to regret and often results in irrational behaviour. You may allocate your investments on some arbitrary measure that takes the decision making out of it, or you may decide not to start your own business because you don’t want to be responsible for failure. Either way, the decision is an emotional one.
Self Attribution Bias
This refers to taking credit for good decisions and blaming others for bad ones and in addition to being somewhat delusional, can result in terrible investing, business and life decisions. You portfolio went up because you are so great, but it went down because your portfolio manager sucks. Blaming your employees for your business failures, while taking credit for its success, is another example of this.
Behavioural finance is a fascinating area of study as by identifying the non rational factors that drive individuals, it can help to contribute to a better decision making processes.
on 2011-04-19 14:49 by Ronika Khanna
An interesting article from The Economist on "The Foolishness of Crowds" as it relates to investing behaviour.
Perhaps people are congenitally programmed to follow the herd. Warren Buffett retells the story of the dead oil prospector who gets stopped at the pearly gates and is told by St Peter that Heaven’s allocation of miners is full up. The speculator leans through the gates and yells “Hey, boys! Oil discovered in Hell.” A stampede of men with picks and shovels duly streams out of Heaven and an impressed St Peter waves the speculator through. “No thanks,” says the sage. “I’m going to check out that Hell rumour. Maybe there is some truth in it after all.”