Behavioralists believe that:
- Investors are not rational in present and future valuations of securities.
- There are substantial barriers to efficient arbitrage.
The Irrational Behavior of Individual Investors
Overconfidence
People tend to be overconfident, e.g. in a survey, 94% of male respondents believed that their athleticism was above average.
Hindsight bias makes the world seem predictable. Investors might think they can beat the market.
The tendency of “growth” stocks to underperform “value” stocks shows how overoptimistic growth forecasts are.
Biased Judgments
People think that \( HTHTHTHTHT \) is a more random outcome than \( HHHHHTTTTT \).
People tend to misuse similarity as a proxy for probabilistic thinking. If Linda was an activist in her early years, people think ‘Linda is a banker and a feminist’ more likely than ‘Linda is a banker’, despite the law that \( \mathbb{P}(A \cap B) \le \mathbb{P}(A)\).
People discount Bayes' Law. For instance, if they see someone who looks like a criminal, they fail to consider the low % of people that are criminals.
Herding
Groups make better decisions only if more information is shared and differing points of view are considered.
Investors have been observed to purchase stocks only because prices were rising. Charles Kindleberger: There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.
The most recent example being TSLA to $900.
Hong, Kubik and Stein found that mutual-fund managers are more likely to hold similar stocks if other managers in the same city were holding similar portfolios.
The average investor underperforms the stock market in the long run because they buy at peaks.
Thus the need for holding stocks over an extended period of time, and dollar-cost averaging. Buffet’s remark on rejoicing when the price of hamburgers goes up is apt in this case.
Loss Aversion
Kahneman and Tversky found that to make people accept a fair coin flipping bet, the subject (on average) had to win $250 or lose $100. Therefore, losses are about 2.5x more painful than wins are desirable.
Kahneman and Tversky also discovered a “framing” effect:
- Program A will save 200. Program B has a one-third probability of saving everyone, otherwise no one will be saved.
- Program A will kill 400. Program B has a one-third probability that no one dies, and two-thirds probability that everyone dies.
In scenario 1, two-thirds of the people picked Program A as more desirable. In scenario 2, 75% chose Program B.
Pride and Regret
Investors sell a stock that has risen in order to realize profits and build self-esteem. This incurs capital gains tax.
Investors hold losing stocks to avoid realizing regret and loss. They miss out on tax deductions.
Behavioral Finance and Savings
Making employees have to opt out of 401(k) plans increases participation rates. People procrastinate a lot and have a status quo bias.
People view retirement contributions as a loss of current spending availability. Thaler-Benartzi overcame this by making employees commit salary increases in advance to retirement savings.
Limits to Arbitrage
The market may remain irrational longer than the arbitrageur can remain solvent.
Hedge funds, the natural arbitrageurs, were net buyers of the dotcom boom! They were in it for the greater fool.
Short selling may not be possible or may be severely constrained.
A close substitute for the overpriced security to offset the short may be hard to find.
What are the Lessons for Investors from Behavioral Finance?
If you sit down at the table and can’t figure out who the sucker is, get up and leave because it’s you.
Avoid herd investing, e.g. gold in the early 80s, Japanese real estate and stocks in the late 80s, internet-related stocks in the late 90s, bitcoin in 2017, …
Avoid overtrading. All you get are transaction costs and more taxes due. If you do trade, sell losers, not winners.
Be wary of new issues. IPOs are historically a bad deal. Hot IPOs are usually snapped up by big institutional investors.
Distrust foolproof schemes. Madoff’s genius was promising 10-12% per year, which seemed reasonable to most people. But recall that despite the US stock market averaging 9%, it was down 40% in some years.
References
- Unlikely Optimism: The Conjunctive Events Bias. fs.blog . Apr 6, 2020.
The Linda example was popularized by Amos Tversky and Daniel Kahneman as the Conjunction Fallacy .
Thinking in frequencies instead of probabilities may temper this fallacy: what is the frequency of bank tellers vs the frequency of feminist bank tellers?