Behavioral Finance 101 (Part 1)

Key Points

  • Human behavior is subject to pervasive bias that rational observers would consider to be irrational.
  • Such irrational behavior is consistent with how investors often approach the financial markets, which over time can degrade investment returns.
  • Therefore, it behooves investors to better understand common behavioral biases when making investment decisions.
  • As an example, overconfidence can lead investors to overestimate their ability to beat The Street.

The World Is Full of Bad Drivers

There’s not much that we can all agree upon. But there is one thing that I’m sure we can all come to terms about—the clear and simple understanding that the world is full of bad drivers. In fact, the first thing we learn in defensive driving school is the notion that we should all drive as if every other vehicle on the road is driven by a maniac because chances are you will encounter one at some point or another (or even on a daily basis for those fortunate enough to reside in Florida).

Without doubt, the world needs better drivers. Chances are you’ve made this comment to yourself and others at some point in your life. After all, if everyone just had it in their right minds to drive as skillfully as you do, our roads would be a much safer place. So here’s a quick unscientific poll for you to consider:

The interesting point about this poll is that the results should be obvious to us all even before we look at its results. Essentially, the question is naively attempting to determine the percent of drivers that think they driver better than the average driver. Accordingly, if we were rational beings, we would expect just over 50% of those surveyed to answer “yes”; i.e., only about half the population should be better than the average driver.

But as you can see, or very easily imagine: most (that is, much more than 50%) people consider themselves to be better than the average driver. Svenson (1981) ran a similar, and much more scientific experiment when he asked a sample of Americans and Swedes this type of question. The results are not likely to surprise you at this point. He found that more than 90% of Americans and about 70% of Swedes thought of themselves to be more skillful drivers than the average driver, which is obviously much higher than 50%. So what’s going on here? The answer is simple—we are overconfident beings that tend to overestimate our ability.

Cognitive Distortions or Human Nature?

In psychology, we understand very clearly that irrationality can take hold of some individuals. However, we prefer to label these individuals as mentally deficient or emotionally challenged, to say the least. But what if the majority the population is susceptible to irrationality? We can’t all be crazy, right?

“Cognitive distortions are thoughts that cause individuals to perceive reality inaccurately.” – Wikipedia

We began our journey in unraveling the financial markets by diving into how the markets are governed by rational participants. Based upon this line of thinking, known as the Efficient Market Hypothesis, we consider the price of securities to accurately reflect all available information such that no individual investor should have a consistent edge over the market as a whole, and as such, the price of securities should reflect their true and fair value. But soon after, we nevertheless noted that the financial markets provide clear evidence of irrationality, citing the pervasive boom and bust cycles of the markets as an example of extreme optimism and pessimism that we notice time and again.

Given all this, we’ll take a deeper dive into how irrationality plays into the markets and then ultimately, we’ll discuss what this all means for you, the avid investor. Essentially, there are two pieces to this puzzle. First, we must understand how investors can act irrationally (which will be the focus of this series). Second, we will review how rational investors try to exploit the irrationality of other investors in order to come out ahead (which will be the focus of Behavioral Finance 201). This entire branch of study falls under a prolific branch of investment research known as Behavioral Finance.

“The behavioral biases…are ingrained aspects of human decision-making processes. Many of them have served us well as ways of coping with day-to-day choices. But, they may be unhelpful for achieving success in long-term activities such as investing.” —Vanguard UK

The underlying notion here is that humans are irrational beings. As such, our species is prone to making decisions based upon an imprecise understanding of information rather than on a rational, unemotional analysis of clear and irrefutable facts. These various anomalies can be classified into different behavioral biases that we all exhibit from time to time. Sound investing comes down to understanding when these biases may come up and not letting our emotions get the best of us when they do.

Overconfidence Bias

Let’s begin with Overconfidence Bias. As the survey above attempts to illustrate, it’s common for humans to overestimate their skills. Perhaps there’s an evolutionary advantage to this; after all, who would dare volunteer to fight in a war, cross an uncharted ocean in a leaky sailboat, or start a restaurant in Manhattan, if that individual really grasped the true odds of success. Nevertheless, it is precisely because we as a species dare to endeavour the impossible that we are ultimately so successful—collectively that is. The individual, however, may not fare so well.

Back to our overconfidence/skilled-drivers example from above. I surmise that you would see similar results when it comes to a survey of professional active investors. Meaning, if you asked a group of professional active investors to raise their hands if they think they are more skilled than the average investor, I’m pretty sure you’ll get more than half to raise their hands—after all, why would you actively invest if you didn’t think you were better than average? But as we’ve noted most active funds (more than 50%) don’t end up providing much value based upon previous historical analysis of large-cap funds. In fact, research suggests most outperforming managers are just lucky, and thus bring no skill to the table. Clearly, the financial industry is ripe with overconfident participants; however, you certainly don’t need to be one of them.

In Part 2 of this series we’ll dive into other more common behavioral biases; some which I’m sure you’ve fallen victim to at some point in your investing career. Nevertheless, the first step in avoiding these pitfalls is to know about them in the first place.