Along with Gene Fama and Lars Hanson, Robert Shiller was recently awarded the Nobel Prize in Economic Sciences for his impressive contribution to the understanding of asset prices. His biggest contributions are in the area of behavioral finance: explaining and understanding the prices of assets through behavioral phenomenon. Others such as Daniel Kahneman, who won the Nobel Prize in 2002, also contributed greatly to this field.
Today I will attempt to highlight some of the most important lessons we can learn from behavioral finance showing that we can be our own worst enemy.
Humans tend to think about ourselves as above average. A common example is to ask a room full of people, “Who thinks they are above average drivers?” Inevitably 90% of the room raises their hands. Of course only 50% of people can be above average, but that doesn’t stop people from seeing themselves as above average. When it comes to investing even though most individuals acknowledge that beating the market is incredibly hard to do, many believe they are one of the few that can do it. This overconfidence leads to poor investment outcomes. Remember that alpha, or outperformance, is a zero sum game. If you win some other active investor must lose. Passive investors are out of the game. If you are picking stocks or timing the market, then you are competing with some very smart and motivated institutional investors.
Sometimes living or working at a certain place leads people to think they know something they don’t. Studies have shown that people living in Atlanta own an oversized position in Coca Cola than the rest of the population. The same is true for St. Louis residents and Anheuser-Busch. Obviously living in these cities gives you no extra information about the stock, but people tend to confuse the familiar with the safe. Studies also show that employees willingly own an above-average amount of their company’s stock. This not only concentrates your financial risk by owning your own company’s stock, but it also incorrectly assumes that you have extra information about the company itself. Everything you know is already known by the market; and if this is not the case and you possess inside information, it is illegal for you to act on that information.
An individual is prone to poor investing behavior, but groups of people can be even worse. Robert Shiller blames herd-mentality thinking as the reason bubbles form and the pain they cause when they pop. Greed and envy can cause people to jump on the bandwagon just because they see someone else making money. The two most recent examples of this are the tech bubble in the late-1990’s and the housing bubble in the mid-2000’s. Investors caught buying high who now hold a losing asset are able to feel better about themselves because they were among many who did the same thing. People prefer being wrong and in good company over being wrong and alone. This leads them to be willing to jump into an investment they have reservations about since they don’t want to be the only one not making big money.
A person holding a losing asset can be impacted by the endowment effect: the effect already owning an asset has on whether or not it is a good investment. A good way to tell if you fall victim to this effect is by asking yourself, “If I didn’t own this house/stock/etc. would I buy it right now at the current price?” If the answer is no, then you are irrationally holding that asset. On the flip side if you own an asset with a large gain, do you think you are “playing with the houses money”? Asking the same question of whether you would buy that asset at the current price will tell you if you are being rational.
After a bubble pops the airwaves get filled with outraged politicians and other commentators wondering why nobody saw this coming. This hindsight bias leads people to believe that it was all so obvious to anyone who was paying attention. Of course, this not true as there is no reliable way to tell a bubble is forming while you are in one. (Shiller would disagree, but there is not enough data to know if he can accurately predict bubbles in asset pricing. Oddly enough, if he proves a reliable way to spot bubbles they may get arbitraged away before they grow too big). Research shows that once you start believing the bubble was so obvious, it leads you to think you won’t be fooled the next time there’s a bubble. You start remembering all the times you were right about the markets and blaming all the times you were wrong on not focusing on the correct things. Next time you will get it right. This leads to the overconfidence we talked about earlier and the cycle repeats.
There are many bias we humans bring to the table, and I just talked about a few. I’m sure you can identify with some of them. The good news is you can do something about it! How? The first step is to be aware that these biases exist. Every investor should take the time to study these effects. The second step is to develop an investment plan that relies on a process instead of your own intuition. Using a rebalancing table is an example of a process that forces you into the correct, but hard, decision of selling high and buying low. Controlling your behavior is the secret sauce that separates good investors from bad.