Behavioral Finance Reveals How Bias May Hurt Your Investing

Behavioral Bias may hurt Investing Results

image credit: Paramount Pictures, “The Big Short”

“He must have been dropped on his head a lot when he was a child.”

Clearly, we don’t often use this phrase to say that someone is a great investor. But maybe we should?

Researchers have learned a lot about the human brain in the last few decades. One study from Stanford University examined how a group of people made investment decisions. The twist of this particular study, however, was that a certain portion of the group had previously suffered brain damage in the area responsible for your emotions. The findings were interesting — the brain-damaged group performed better and made more rational investment decisions than the “normal” group.

Now, obviously, the takeaway is NOT to go ram your head into a wall somewhere to increase your portfolio’s value, but rather that understanding how our minds naturally relate to investment decisions is an important part of investing. In the above-mentioned study, the reason that the brain-damaged subjects did better is because the emotion center of the brain, the amygdala, was inhibited from interfering with the neo-frontal cortex (or, higher-level analysis part of the brain) in its cold, rational investment considerations.

This is just one example of a growing body of evidence suggesting that compared to the sterile calculations of a financial calculator, the investment decision-making process for the number-cruncher in our cranium is a bit more complicated. We are social, emotional creatures driven by pride, fear, and sometimes even a little capitalistic fervor (aka “greed”). However, as investors, we should be more focused on simple ROI (return on investment) calculations. Within the context of biology, this makes sense. In the wild, the human mind’s ability to make quick, snap decisions based on a “gut feeling” could save us from a lurking predator. However, these tendencies of the human mind can be much less advantageous in the modern financial world. The good news is that an experienced, informed investor can learn how to counteract the natural tendencies of the human mind, and to substitute sound, unemotional logic. In fact, that’s why many people choose to outsource their investment management to a seasoned professional like the professionals at JPH Advisory Group. There is an advantage to breaking the emotional connection between an investor and his/her money, as ideally it allows a third party to be more objective.

Here are three cognitive biases from behavioral finance that investors would do well to be aware of.

Hindsight Bias: “I just KNEW that was going to happen.”

As the saying goes, “hindsight is 20/20.” In common, everyday language it’s known as “Monday morning quarterbacking,” but academic researchers have clearly confirmed this cognitive bias in multiple scientific studies. While in most instances of everyday life, it is relatively innocuous, in the realm of investment decisions, it can be very harmful.

For example, coming out of the Global Financial Crisis the question on the mind of many investors was “why didn’t I see this coming?” Since science has shown that pain of permanent financial loss is greater than the joy of financial gain, this tendency became even stronger to find a way to explain “why this happened to me.” Suddenly, all the doomsayers and financial prognosticators come out of the woodwork claiming to have predicted this, and many people want to join in due to the effect of Hindsight Bias.

The danger here is that embracing that tendency has important ramifications for future investment decisions. If you truly believe that somehow deep down you actually did see the last recession coming, then clearly market timing is possible and in fact, vital to your financial success. However, the evidence says otherwise. Once an investor wholeheartedly believes that myth, he/she will throw time, energy, and missed investment opportunity down the “wishing well” of market timing, only to find in the end that a disciplined, long-term investment strategy will, in all but the very luckiest of scenarios, have served him/her far better.

Confirmation Bias: “The world is ending. Now let’s find some data the confirms that fact.”

Confirmation bias is one of those tricks of the mind that is almost impossible to avoid. Our brains are great at taking data and forming patterns from it to find meaning. When new information is introduced, it is much easier then to fit that data point into the model we have built of the world, rather than rebuild the model around the new data point. Its something we do constantly and unavoidably.

A recent study from the University of Iowa backs up the mountain of evidence already out there for confirmation bias. In this study, students prepared a detailed written analysis attempting to predict the future success or failure of Hollywood movie releases. Then these same students traded real money contracts predicting the four-week open box office receipts of these movies. The results of the study demonstrated that students who had written analyses predicting the success or failure of the movies were much less likely to change their minds upon receiving new information. Even after the first two weeks of results came in, prices rarely moved to reflect all the available information in the market. In other words, even with real money at play, and even with obviously new important information, people are reluctant to change their minds. Tom Gruca, the study’s author, sums it up by saying “this study shows that when all traders in a market have the same bias—in this case, confirmation bias—market prices are not efficient and do not reflect all of the information available.”

In the investment arena obviously this can be very dangerous. If you believe that the world is ending, it’s just a matter of when, then almost any data point can be construed as negative, when given the “right” context. Conversely, if you only see blue skies ahead, each new contradictory fact may seem like just a temporary blip on the way to double-digit returns. A flexible attitude and the willingness to listen to opposing views is crucial for success as an investor.

Herd Mentality/Group-Think: “What is everyone else doing?”

We all like to think that, as investors, we weigh all the evidence presented to us rationally before making a decision. We are independent agents, forming our opinions only upon data presented, and not upon the peer pressure of others. We are like John Maynard Keynes, who is attributed with saying, “when events change, I change my mind. What do you do?” However, social scientists have known for a long time that herd mentality is quite active among humans. As social creatures, we find safety in numbers and in the validation of others’ opinions. Surely, we all can’t be wrong at the same time? For this reason, its often an uncommon personality type that can remain immune to these social forces in the pressure-packed world of investing.

In the years coming out of the global recession of 2008, I remember reading Michael Lewis’ soon-to-be-classic “The Big Short.” He does a great job chronicling the misadventures and excesses surrounding the Housing Market Bubble, and identifying the few investors who saw the house of cards crumbling. One of these was an eccentric hedge fund manager named Dr. Michael Burry. Locked in his office for days at a time reading mortgage-backed prospectuses, he saw the sub-prime mortgage crisis for the financial tsunami that it was, and stood toe-to-toe directly against the established investment world to make aggressive contrarian bets against it. Interestingly, Dr. Burry was known for having a glass-eye and a mild form of Asperger’s Syndrome, which hampered his social interactions and made him feel comfortable since childhood with being alone. (By the way, in the recent Hollywood blockbuster based on the book, Christian Bale does a tremendous job of capturing the eccentricities of Burry’s character.) Many believe it was this lack of social connection that made him so willing to stick to his convictions against the mainstream view. As we all know, he was eventually proven right and profited tremendously for his acumen and intestinal fortitude.

Unfortunately, most of us don’t have the internal courage of Dr. Burry. However, what we can do is be aware of our tendency towards group think, and develop an internal “Devil’s Advocate” that constantly questions the mainstream viewpoint.

Conclusion

Because all investors, at least the human ones, face the same behavioral biases that can potentially lead to poor decisions, it is critical to utilize fund managers with consistent, clearly defined investment process. With a consistent strategy designed to reduce reliance on human intuition they are less likely to be prone to these decision errors, and can construct an intelligent strategy designed to counteract the effects of behavioral bias. Additionally, through experience many great investors have learned to recognize the behavioral biases that affect most investors, and have used that knowledge to spot opportunities, as well as to develop strategies to help prevent them from making the same mistakes. On the opportunity side are managers who seek to exploit decision errors that have resulted in unrealistic and unsustainable valuations. Although this approach is more quantifiable in the area of value investing, certainly many growth managers also factor distortions of intrinsic value into their investment decisions. As for avoiding errors, techniques have been constructed by many investment teams that are helpful to consider. For example, some managers establish clear sell criteria that can vary among a range of reasons, including a downturn of more than 20% in a steady or rising market, for example. Other procedures we see often in successful managers include requiring a sale in order to purchase something new and the active testing of assumptions by other team members, among many others.

Much of the benefit to be gained from understanding behavioral biases will result simply from remembering to consider them in evaluating investment opportunities and before making final decisions. Few would dispute that most are obvious; the challenge in overcoming them lies in their largely reflexive, unconscious nature. As a Personal CFO and portfolio manager for dozens of clients all around the Southeast (and even the world), we have developed our own internal processes designed to counteract these common behavioral finance decision errors, and thereby add value to our clients’ portfolios over the long-term.

 

 


Sources

Stanford GSB Staff (2005, September 1). Baba Shiv: Emotions Can Negatively Impact Investment Decisions. Retrieved July 13, 2016, from https://www.gsb.stanford.edu/insights/baba-shiv-emotions-can-negatively-impact-investment-decisions

Woo, M. (2012, November 25). Reducing 20/20 Hindsight Bias | Caltech. Retrieved July 13, 2016, from http://www.caltech.edu/news/reducing-2020-hindsight-bias-37563

Wolfers, J. (2015, August 24). How Emotion Hurts Stock Returns. Retrieved July 13, 2016, from http://www.nytimes.com/2015/08/25/upshot/how-emotion-hurts-stock-returns.html

Riepe, M. (2013, December 16). Does Market Timing Work? Retrieved July 13, 2016, from http://www.schwab.com/public/schwab/nn/articles/Does-Market-Timing-Work

Snee, T. (2015, November 12). See? I was right. Retrieved July 13, 2016, from http://now.uiowa.edu/2015/11/see-i-was-right

Mackintosh, J. (2016, May 16). The Real Fear Is When We All Fear Alike. Retrieved July 13, 2016, from http://www.wsj.com/articles/market-groupthink-will-be-bad-if-things-are-good-1463416598