Behavioural finance and Human errors in DIY Investing

You can think about it.

You can think about it a little more.

But it won’t matter, because both of these treatments are identical. Yet in 1981, Daniel Kahneman and Amos Tversky found that nearly ¾ of respondents chose Scenario 1.

“Saves 200 lives” sounds a lot better than “400 people will die”.

This is called framing bias.

Framing bias: half full, or half empty?

When I interviewed the very generous behavioural economist Meir Statman, he told me that framing bias was the most powerful cognitive bias afflicting investors.

It is not the only one, however. Numerous studies show that it’s actually the behaviour of investors, rather than the behaviour of investments, that contributes most to investing success.

Or failure. And the more “behaviour” investors apply toward their own investing, the worse those results.

I know of no study showing that investors outperform simple indices. I know of several showing that they don’t.

One is a long-running and annually updated analysis by Dalbar Research, which basically shows that year after year, individual investors substantially underperform simple indices.

Why behavioural finance matters, in one chart:

Source:Dalbar Research

In Dalbar’s own words:

Namely, the set of longer-term data analysed in these QAIB reports clearly shows that people are more often than not their own worst enemies when it comes to investing.

Often succumbing to short-term strategies such as market timing or performance chasing, many investors show a lack of knowledge and/or ability to exercise the necessary discipline to capture the benefits markets can provide over longer time horizons. In short, they too frequently wind up reacting to market maturations and lowering their longer-term returns.

In the 2022 edition of the study, Dalbar also concludes something that we often tell our prospects and clients: Investment results are more dependent on investor behaviour than on fund performance.

Want better investment results? It’s like a relationship: work on yourself first. (Don’t ask me how I know this...)

Interesting but unrelated framing example

Which line is longest? They’re all the same. This equal-line Müller-Lyer test may fool you, but researchers in the 1970s found it was unlikely to fool members of the Zulu tribe living in southern Africa. At least at that time, Zulu life didn’t include a lot of arrows and geometric shapes, so their minds were less fooled by optical illusions.

The investing universe is almost ignoring the biggest driver of success or failure

If you scanned all the ink that was spilled, words written, ideas shared, podcasts made, talking head comments uttered, and all the collective to-do about investments, my unscientific guess is that it would be at least 99 times – and perhaps 999 times, and perhaps even 9,999 times – more than the collective discussion about investing behaviour.

On one hand, this would be like opening a restaurant menu and seeing copious information, photos, testimonials, etc, about the appetisers, and having to pull out a magnifying glass to read about the main courses in fine print.

On the other hand, it’s an improvement. Behavioural finance was looked down upon initially by finance academics, who tended to think that which could not be quantified must not exist (or must not be important if it does exist).

Anyway, let us move step by step.

Southbank Investment Daily cannot solve all of society’s problems, or perhaps even any of society’s problems, but since I’ve talked so much about behavioural finance already, I’ll at least walk through two useful bits:

1. Some of the most common cognitive biases that snare investors

2. Three solutions or mitigation strategies.

Let’s proceed.

Anchoring bias

Researchers at the University of Idaho – yes, Idaho has universities – sent a faux secretary to a series of job interviews. When asked about her desired salary, in some interviews, she replied jokingly, “I’d love $1,000,000, but really, I just want what’s fair.” In others, she said only “I just want what’s fair.”  In the interviews where the secretary mentioned $1,000,000, she was offered 10% more salary.

That’s not much more, but it also didn’t require much effort, either.

Examples of anchoring bias

1. You lost money on a share but want to hold it until it breaks even (you’re anchoring on your price paid, which is something neither the share nor the market care anything about).

2. You avoid a well-performing share simply because you eyed it “back in the day” when it was far cheaper, and now, relative to that, it just seems too pricey. As we’ve discussed in these digital pages recently, many of the best shares have risen in excess of 10,000%. Someone who declared them “too expensive” after the first 100% or 200% gain missed far more.

Confirmation bias

On October 13, 1972, a plane carrying a Uruguayan rugby team crashed at 3,600 metres altitude on a glacier in the Andes. The next day, the survivors were elated to see a plane fly overhead and tip its wings – a sure signal that it had seen the stranded men. Except the wing tip was random; the pilots hadn’t seen the men. The team had to wait another 72 days before being rescued, resorting to cannibalism of teammates who died in the crash to stay alive, and stuffing fat from the corpses into their boots for insulation.

“People generally see what they look for and hear what they listen for.” – Harper Lee

Confirmation bias is what it sounds like. We see what we want to see. It’s probably a bigger societal problem in social media, where birds of a feather can too easily flock together and, thanks to algorithmic information feeds, bathe exclusively in opinions of their own choosing, at the expense of anything disconfirming or mind-opening. (I’d never thought it would be a good idea to force people to occasionally entertain opposing opinions, but this idea is looking less unreasonable by the year.)

Example of confirmation bias

You’ve decided that a share you’ve bought is a good share so, naturally, you seek out and overweight information that proves your genius, whilst effectively devaluing information to the contrary.

Consistency bias

We hate the idea of acting in a manner inconsistent with our vision of ourselves. Unfortunately, we do it often. An inconsistent identity is unbearable, so our subconscious minds reshape “facts” to make them more consistent with the beliefs we’d prefer to have about ourselves.

Greg Markus from the University of Michigan asked people’s attitudes about various political issues, beginning in 1965, and following up in 1973 and 1982. He found that people’s views became more conservative with age, but 70% of participants incorrectly believed they’d had their same views all along.

And in a 2015 experiment on “earned dogmatism”, Loyola University researchers divided randomly chosen people into two groups. They presented one group with easy political knowledge questions, and sometimes falsely praised the easy test takers for having “high expertise.” Researchers gave another group difficult questions, sometimes telling the difficult group that their political knowledge was “below average”. The researchers then gave all groups a common test measuring political open-mindedness. The people falsely convinced that they were experts immediately became more closed-minded (the red bars on the chart). They believed that their expertise entitled them to disregard other ideas.

Source: Journal of Experimental Social Psychology (via ScienceDirect)

Example of consistency bias

I think that people who like to be right are most vulnerable to consistency bias. That’s probably all people, but it especially includes many in this industry (investing, financial advisory, financial media, etc). It’s hard to admit that a strongly expressed view is wrong. And economics and investing have the accidentally enabling virtue of being cyclical – just as if you save your clothes long enough they’ll come back in style, if you hold to a viewpoint long enough and eventually it’ll be “right”.

Of course, when we buy a share we feel is undervalued – which is generally the only time we’d buy a share – we’re essentially participating in something akin to this.

But certain “cults” within investing seem – perhaps aided by self-reinforcing communities (confirmation bias) – particularly beholden to this bias. How many gold bugs change their tune? I have yet to see one. And the share market perma-bears look like geniuses now, but some of them were preparing for a collapse 15 years too early. What about those bitcoin maximalists who espoused the riskier and now-very-ponzi-looking crypto investments that are now down 90% or more?

Herd mentality

Let’s move a little faster. This bias is also self-explanatory. Have you seen restaurants or websites flagging items as “popular” or “most popular”? They’re playing off your instincts to follow the herd – and it often works. A lot of younger investors – those getting ideas from social media – seemed especially vulnerable to this bias recently (as did those in the American dot.com bubble). Unfortunately, as the crypto and Game Stop crowd has learned, there’s not long-term safety in numbers in capital markets.

Loss aversion

Some research has shown that people feel the pain of a loss two or three times as strongly as they feel the pleasure of an equivalent gain. In investing, this causes people to hold losers when they should be selling them, simply because investors don’t want to fully realise that pain. Certain academics have now questioned the initial research behind loss aversion, but for now, it’s still mostly accepted.

Representativeness bias

Unscientifically, this is when people make too big a judgement from too small a data set, or substituting similarity for probability as some people put it. Cryptocurrencies were hot last year and the year before? That probably means that… cryptocurrencies are always going to be hot, then.

Tversky and Kahneman, this time in 1983, pointed out representativeness bias via a question that tests for something called “conjunction” or “nesting” error:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

a) Linda is a bank teller.

b) Linda is a bank teller and is active in the feminist movement.

To be precise, you don’t even need to read the question to answer correctly. Just look at the answer choices. It’s easier for one condition to be true than for that condition and another. But Tversky and Kahneman did, indeed, find that many people answered “b”. Our minds tend to jumble things, nest thing, and assume causality and correlation even when it doesn’t exist.

Activity bias

This simple bias represents the tendency to want to “do something” when things go awry. This is absolutely wonderful, and not a bias, if your house is ablaze. Your instincts to flee whilst grabbing as many electronics as possible are correct. Besides our innate wiring, society conditions us to feel guilty – and lazy and irresponsible – if an emergency is happening and we’re not doing something.

But with investing, a social science, where prices react – and often temporarily overreact – quickly, the best thing to often do in an emergency is nothing.

Conclusion: we’ve not wired for investing

The list of biases is longer than I can cover in one piece; perhaps I’ll do more on this one day.

But two points in summation:

1. Don’t feel bad about being biased. Big picture, these biases are evolutionary features, not bugs. We’re built to handle deterministic sciences well: touch a cactus; it’s prickly. Touch another cactus; it’s also prickly. See a third cactus and you don’t need to poke your hand again (unless you’re James Early).

2. We still need to face these demons. Human heuristics fail with a nondeterministic, stochastic social science like investing. But they result in such massive lost benefit (through avoidable errors) that they need to be respected and dealt with as a “thing”, which investing as a field is still on the early side of accepting.

So how to deal with cognitive bias? I’ll offer three ideas:

1. Awareness: this will help with some of the biases, but not all. Easy start: keep a log of why you’re buying a share and what would make you sell.

2. A financial adviser: I prefer fee-only advisers, who seem more expensive but who come without the bias (we’re trying to get rid of bias, remember?) of a big investment institution pushing its own research and inventory.

3. An investing club: this could be a mixed bag: good for pointing out your flaws and keeping you accountable; bad for introducing social pressures. Tiger 21 is a famous club for wealthier investors who bare all and review each other’s portfolios periodically.