Most economic and financial theories are based on the concept that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence indicating that this is frequently not the case.
Behavioral finance is the study of the methodical errors made by market participants due to psychological biases. The father of behavioral economics, Daniel Kahneman, has inspired a new generation of researchers in economics and finance to enrich economic theory using insights from cognitive psychology to look into intrinsic human motivation.
Now, even the US Securities and Exchange Commission has an investor education site, investor.gov, which includes a comprehensive summary of what we have learned over the last 30 years about how we investors behave and the mistakes we make.
Kahneman, in his book Thinking, Fast and Slow, arrives at a few surprising conclusions, quoting quite a few well-researched papers. He finds that most active traders fare poorly or at least make no gain over the years, while the largely inactive trader stands to profit the most, which also means that individual investors should not buy and sell too often to make the odds work for them.
Individual investors have a tendency to sell “winners”, stocks whose prices are going north, and hold on to “losers”, thereby adding to losses to their portfolio. Men are more prone to this mindset than women, who end up making more profits. And men not only sell but also buy the wrong stocks because they largely tend to invest in companies that are in the news. This leads to sub-optimal decisions in a variety of circumstances.
In the case of stocks, there is a tendency to hold on to stocks that have lost considerable value since the date of purchase. Several examples spring to mind from recent years.
For instance, investors in shares of BUMI are probably amongst the ones who have fared the worst badly. As late as May, shares of BUMI traded at Rp 2,000 (20 US cents). Since then, share prices have consistently fallen but at each point, investors expected that the fall would be arrested and the price would rebound.
This has led shareholders to keep, rather than sell their shares — not because of some conviction about a change in fortunes, but because of an aversion to booking losses. The side-effect, however, has been an even further loss, with shares now trading close to Rp 730 as of last Friday.
Consider the reverse condition — rarer — but one that certainly does occur. For instance, the shares of a company were trading at Rp 100 at the end of 2011, but began a sharp upward rally and by mid May had increased to Rp 700.
While the stock was now much riskier at Rp 700 per share, those who had purchased the share at Rp 100 were quite complacent, on the grounds that there was no way they could lose money.
Quoting these studies, Kahneman rightly points out that financial institutions are also not immune to this type of thinking. There is 50 years of research to testify to this belief — that the selection of stocks by investors and traders was based on a mere roll of dice rather than a skillful game of poker — as at least two out of every three mutual funds have underperformed the market in any given year.
Therefore traders, mutual funds and overactive individual investors need to watch out for this tendency. In the guise of making sensible, educated guesses in a situation of great uncertainty, portfolio managers milk the Richie Rich and the gullible when it all boils down to little more than sheer luck.
Studies have shown that in highly efficient markets, educated guesses are no more accurate than blind guesses.
However, firms reward their fund managers as if their task were a matter of skill. Such overconfidence occurs because people are often blind to their own blindness. Kahneman even has a phrase for this phenomenon: cognitive illusion.
Kahneman strongly advocates that we have to learn to unlearn in order to amend and recognize our mistakes. Such a capacity requires true intuitive expertise and only comes from experience. Then again, intuition works in different circumstances.
As normal human beings with all our weakness, we are all subject to the forces of cognitive biases. However, by accepting that we may be making sub-optimal decisions due to such biases and by understanding the nature of these biases, the hope is that we can overcome them and become better investors – and therefore wealthier than we might otherwise be.
Kahneman agrees that no one can beat the market, because it goes against the grain of economic theory. A stock’s price is never a true valuation of what it really represents, and any profits or losses are only a function of the speculative nature of stock trading.
If you are wondering why this is no great treatise to “beat the market”, it is simply because only luck can beat the market and luck is not human. We are.
The author is a business and economics writer.