When I started to learn about finance I had the same thought. I could do engineering and learn all of the complicated math and science then why can't I figure out this investing stuff? It's just numbers and I know how to handle numbers. But when I started to really dive in I started to really understand that investing and finance is not just about numbers. It's about so much more. To demonstrate this I want to show you some interesting numbers (who would have thought).
You may have heard that most people lose money in the market. In fact, the vast majority of people lose money in the market. Depending on the source in which you look at, you will read that 90 to 95% of investors lose money in the market. There are many engineers and numbers people that are a part of this cohort. These are staggering numbers when most people first hear them! Many people in the investment industry set out to learn why this is. I think the principles in the post account for the vast majority of that statistic. Before we dive in I want to talk a little more about the difference between STEM and investing.
The Market Is Not Physics
As an engineer it is my job to use math and science as tools to create and design things for our benefit. This is because we have something which we can build a foundation from. The laws of nature never change. Whether we like it or not. Whether we are having a bad day. Whether it is "hard" to understand. Nature doesn't care. There are laws that you cannot break. Once we understand these laws we are able to design systems to use them to our advantage.
With the stock market these laws do not exist. There is no foundation in which we can build our complex formulas off of. There are a lot of numbers, but their foundation is ever changing. There is an entire field of investing called technical analysis that is about using very complicated math to try to guess what the market will do next. I can't say that I have done a whole lot of research on technical analysis, but I feel that the majority of it is finding shapes in the clouds.
Many engineers go into the market looking to capitalize on their analytical skills and make loads of money. Unfortunately many times they tend to neglect the emotional side of investing and end up losing loads of money. This is where we enter the world of behavioral investing...
Enter The World of Behavioral Investing
When this statistic first started to come out there were a lot of numbers oriented people scratching their heads. "But we optimized the trading algorithm how could this be?" Well this is where Daniel Kahneman enters the picture. In 1979 he published his paper "Prospect Theory: An Analysis of Decision Under Risk" which he evetually won the 2002 Nobel Prize In Economics for. This is the point in which the world of finance and psychology truly meshed into behavioral finance. Since then psychologists have made huge strides in understanding how we interact with our money when it comes to investing. Being a well rounded investor can not be accomplished without a real understanding of their work and the implications it has on our portfolios. One by one we will go through some common principles of behavioral finance. Knowing and respecting these ideas is the first step in limiting their effect on our investments. So without further ado let's dive in.
This is more formally known at the illusory superiority bias. This one is fairly easy to demonstrate. Next time you are at a party ask everyone if they think they are an above average driver. Well, maybe that isn't good party conversation. Anyways you will generally find that the majority of people will say they are an above average driver. This study in 1981 found that 90% of Americans ranked themselves in the top 50% for driving skill. Now statistically this isn't possible within the same sample set. This same bias can be seen in many different areas. In one study done at the University of Nebraska they surveyed their faculty and found that 68% of faculty ranked themselves in the top 25% for teaching skill and 90% ranked themselves as above average. Do you think you will easily be able to help those professors teach better? Yeah probably not.
Another place that I personally see this is with financial literacy among people in their 20's and 30's. In a recent study released by NFCC (National Foundation of Credit Counseling) found that 92% of Americans are somewhat or very confident in their most recent big financial decision. Although 70% said that they are worried about their finances. This is a classic example of this bias.
When it comes to investing this manifests itself in how we feel about our portfolio choices. We all feel that we are the ones that can beat the market and that we have it figured out. Another way that this manifests itself is in the frequency of trading. It is very well known that trading quickly rarely leads to higher returns. But making constant moves in the market makes us feel in control of our future. Unfortunately the market is an unforgiving place. This is only scratching the surface.
Another very strong concept in behavioral finance is loss aversion. This was the hallmark that Kahneman found and is formally know as "prospect theory" named after his 1979 paper mentioned above. Simply stated it is the idea that we feel more pain when taking a loss than when taking an equally sized gain. This leads us to do things which are irrational in order to avoid feeling the pain of loss. According to some studies it was shown that losses are twice as powerful as gains of the same amount. This manifests itself in investing when some people tend to sell their winning stocks a bit early to "take some profits" and others tend to hold their losers longer than they should in the hopes they will bounce back.
A simple way to avoid holding losers too long is to ask yourself this question "if I had the same amount of money in cash that I have invested in X would I buy it?" If the answer is yes then you hold. If the answer is no then you sell. All too often I see people holding things with such regret because they don't want to take the loss. Most of the time it only deepens the pain.
Sunk Cost Fallacy
This one is more of a manifestation of loss aversion. It is the idea that we are largely unable to ignore sunk costs when it comes to our analysis of a situation. Let's say for example you purchase a cruise that is non-refundable and you are unable to transfer the tickets. Before going on the cruise you learn that the cruise liner is notorious for having horrible food and all around not good experiences. Most people would choose to go on the cruise anyways because you had spent money on the tickets and booked vacation time and so on. If instead you had won the cruise by chance then most people would probably just skip it. This, however, is illogical. The money you have spent on the cruise is sunk cost meaning you can never get it back. Since you have no way of getting it back, it should not enter in your decision of whether you go on the cruise or not. It should be solely based on your interest. Therefore there should be no difference in the decision outcome between the case where you bought the tickets and the case where you won the tickets. Nevertheless, you see this all the time.
With investing you see this with people holding onto losing positions longer than it is logical to do so. Let's say you buy a stock and the next month it tanks due to underlying business issues. Most people will stick it out in the hopes of breaking even rather than taking the loss and putting that capital to better use elsewhere. Using the same mindset I explained above with loss aversion will help guard against this. If you wouldn't re-buy the stock at the current price then you shouldn't be holding it.
When I was in community college I worked at a store in the mall that sold scratch off lottery tickets among a bunch of other things. Almost every day there was a guy that would come in and spend on average $80 on lotto tickets. He had all of these theories about which ones would be winners. He would ask me which ones were on a new roll or if there had been any big winners we knew of recently on a certain roll. Almost always he would lose money. This is a classic example of Gambler's Fallacy. It is the idea that the probability of an event is dependent upon the probability of another event. In my example, every time you buy a scratch off ticket your probability of winning is exactly the same no matter the circumstances. You see the same mentality with slot machines. Many people will post up on one machine for hours at a time believing that every pull is getting them one step closer to the jackpot. The reality is that every pull has the exact same probability of winning the jackpot as the one before due to it's programming.
This manifests itself in investing with the tendency for people to base their buy/sell decisions on an event that is not related to the situation. Have you ever heard someone hold a losing stock because "a company that big just CAN'T go bankrupt". Ever heard of Enron? The fact is ANYTHING can happen when it comes to the market. Look at the recent deal with Volkswagen's "clean diesel" scandal. A company that large wouldn't engage in outright fraud, right? Think again. To guard against this it is important to make sure all your decisions are based upon thorough analysis rather than whims or rumors.
The next four are really the Mac Daddy's of cognitive biases.
Overreaction and Availability Bias
If you are a reader in the world of economics, you have no doubt heard about the heated debate of whether markets are "efficient" or not. Basically the efficient market hypothesis states that all the information about a stock is currently factored into the stock price and everything is completely rational. Therefore, bubbles cannot exist under this theory. But in reality bubbles appear and bust with great impact. In 1985 Richard Thaler published a paper called "Does The Market Overreact?" You have to remember, at that point in time the efficient market hypothesis was VERY widely accepted as truth so what they were proposing was essentially heresy on the financial gods. What they did was look at 3 years of past stock market data and compare what they called the "winners portfolio" which was the 35 highest performing stocks and the "losers portfolio" which was the 35 worst performing stocks. He then looked at the following 3 years and compared how the portfolios did compared to a representative index. In almost all cases the losers portfolio consistently outperformed the market while the winners portfolio consistently under performed the market. But how could this be?
What they were showing is how the market will overreact to the most recent information. Let's say a company happen to post good quarterly earnings compared to estimates. Most likely the stock will shoot up. Over the long term the investors will realize that the increase might not have been warranted and slowly it will tick back down. Conversely if a company were to post poor earnings the stock would lose. Over time the investors would realize that the loss was not warranted and it will tick back up. This is why we see that the losers portfolio consistently beat out the winners. This was also one of the first times we had hard proof that being a contrarian investor (that is doing essentially the opposite of the crowd) really pays off.
The availability bias accentuates the overreaction theory. This is the idea that we tend to put heavy weight on the most recent information and not as much on past information. This is why the market tends to overreact to short term news and rumors. This makes the short term variation in the stock market very erratic while the long term trends are much more calm.
To avoid availability bias it is important to keep everything in perspective. Following stock tips and short term news is a very easy thing to do and will make you seem like you know what is going on. In reality, it is usually bad for your investments. Learning to take a long term approach to your investing is one of the hallmarks of the pros. The pros are there to profit from the amateur's short term fluctuations. It is the only way to consistently grow your wealth over time.
Confirmation and Hindsight Bias
I could ascribe almost all political/religious/any other heated debates to these two biases. Although I don't really get into those subjects here on this site. Confirmation bias is the tendency for people to look and weight information that supports their previously held beliefs while ignoring or discrediting the information that does not.
I think the best place to see confirmation bias is in the political field as I mentioned. There are so many news outlets that produce very one sided content and people grab a hold of this. When an event happens, they turn on the favorite news channel to hear about what opinions they should have while claiming the people who hold contrasting beliefs are "just idiots". I believe social media intensifies this as it is so easy for information to spread quickly.
In investing this is particularly apparent in how people justify buying or selling stocks. If you bought because you had a strong positive feeling toward a stock then you will tend to seek out news which confirms your thoughts.
Hindsight bias is the belief that an event (after it has already happened) was entirely predictable. This is better known as "20/20 hindsight". You can hear it all the time with people saying things like "oh I saw that happening from a mile away" or saying that "they totally knew" the real estate bubble or oil crash or take you pick was going to happen. The fact of the matter is that it wasn't predictable or it wouldn't have been a shock. And if it was predictable then the people saying that should have just put their money where their mouth was and lock in a position to profit from it. The biggest danger from this is people can sometimes form thoughts that are far too oversimplified. If they then enact this strategy it could cause great loss in their portfolio.
These are quite tricky to overcome. The best way to guard against confirmation bias is to purposefully seek out contradicting information on any given event and to honestly analyze both side for their merits. Somewhere in between generally lies the answer/truth. For hindsight bias the best thing is to understand that people were operating on the best information they had at the time. Although this may not be entirely true it will help curve the tendency to be overconfident in your own abilities to predict the future.
How Do We Put This Together
First thing we need to do is understand that we have programmed tendencies that truly make us horrible investors and especially horrific in the short term. You need to realize that you too fall victim to these and there is no way to completely overcome them using only self control. If you think you have never been victim to any of these then you are a liar and you need to reread the overconfidence section.
Realize that these biases are not mutually exclusive. I would say they are almost always found as a mixture of many. I think of a witches cauldron (maybe because it is close to Halloween) with a nice brew of different combinations that make up almost all of our decisions. Take some overconfidence and mix it with a hefty dose of confirmation bias and hindsight bias and you have a nasty brew that will cloud even the most disciplined investor's thoughts. Take a little sunk cost fallacy with a little gamblers fallacy and you have a brew to make anyone hold their losing stocks for years.
These are just the internal factors within your portfolio. Think about this in the context of the credit cycle. Think of if on top of all these biases you have debt that you took out to invest and you lost a job and so on. It only heightens the effect of these. Even with the greatest self discipline, when you are facing some truly scary situations you will default to human nature. That is why it is so important to know how our tendencies can affect us.
On a more positive note, understanding these and learning to have a deep respect for them is the first step in helping guard against them. Understand that making money with investing does not come down to how good you are with numbers or how fast you can solve complicated differential equations. It comes down to who can learn to master their emotional tendencies. Be weary of what everyone else is doing. Turn off your TVs and news channels. If you can learn to consistently be contrarian to the norm then it is likely you can reap the rewards over the long run.
In The Weeks To Come
In the next posts we will begin to break down how we can create our system to optimize our long term finances. Like process safety (getting to my chemE roots) first we try to design out what we can and then we will attempt to mitigate the rest. This along with the post on short circuiting the credit cycle are laying the foundation of principles which we can begin to build from. Make sure to subscribe to the email list below and like the page on Facebook to follow along!
Huge Database of Papers: http://www.behaviouralfinance.net/
The Little Book of Behavioral Investing By James Montier