Behavioural Finance: Elephant Traps For Investors

Posted on 01/02/2011


“Temperament is… important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.”

Warren Buffet, Berkshire Hathaway letter to shareholders, 2006

Attempting to apply a mechanical model to investing often fails because market conditions change over time, meaning that a strategy that has worked for a certain historical period may not continue to work in the near future (though may work again further into the future).  Consequently, human decision-making is required.  Even quantitative/algorithmic trading firms need people to continually refine the and update the “black-box” models. Most investment firms rely entirely on human decision-making  in order to design and execute their investment strategy.  However, once humans enter the equation, so do behavioural biases that affect people on an almost universal basis. These behavioural biases, to which everyone is susceptible, have the potential to severely impair the returns on an investment portfolio.  Below I discuss some of common biases.

Confirmation Bias is the process of emphasising evidence that supports an individual’s existing viewpoint, while also becoming blind to evidence that contradicts it.  This is very common in politics as politicians, charities and lobby groups have entrenched positions which they attempt to develop into a society-wide conventional wisdom by publicising only the evidence which supports their existing viewpoint.  While this battle for the truth and ideas by opposing factions at the societal level is a useful part of the political process, for an investor this can be highly dangerous as it blinds him/her/the institution to what may be essential evidence that undermines an investment thesis.  Unless such evidence is properly analysed, then the investor risks making a mistake.  Because of this, it is important to seek-out (and attempt to refute) evidence or opinion which contradicts your current position.  This excellent article from EPL Talk looks at the issue of confirmation bias in football referees.

Herding. As John Maynard Keynes wrote in the General Thoeory of Employment Internest and Money, “worldly wisdom teaches that it is better for reputation to fail conventionally then to succeed unconventionally.”  Herd behaviour is the process of copying the investment decisions of other investors.  While there may be sound fundamental reasons for the initial investment decision, the case can often become an unchallenged conventional wisdom (ie. “house prices can never fall” or “the invention of the internet has created a new type of economy”) leading the the development of a bubble.  Because other investors have made the same decision, an investor feels a greater level of comfort in his or her decision because it is being confirmed as “correct” by a large crowd.  Going against the crowd can also be difficult due to career risk or the costs of running short-positions in over-valued but still-performing assets.  [Note: This also impacts sell-side equity analysts, who tend to cluster around consensus forecasts.  If the consesus is wrong, then the company typically gets the blame/credit for an earnings miss/beat while if an individual analyst is wrong he may be in danger of losing his job].  By engaging in herd behaviour (particularly if a bubble has developed), an investor risks losses when the original investment thesis is finally shown to be weaker than first imagined and investors rush to exit their positions, forcing-down the price.  Sometimes though, herd behaviour can be sensible.  If a bank run has begun, then it is rational for an investor to participate in order to avoid losing his or her savings.  David Scharfstein and Jeremy Stein of Harvard Business School look at the issue in more detail in their research paper “Herd Behaviour and Investment“.

Mental Accounting. A concept first formulated by University of Chicago economist Richard Thaler, when applied to investing this is the prcoess of segmenting a portfolio into various compartments and thinking each should have a different risk/return objective.  Often, an investor may place a certain amount of money into a separate account from the main portfolio, mentally-labelling it a “high-risk account” containing money that he/she can “afford to lose”.  This makes no sense at all.  The only metrics in which the investor should be interested are the risk/return characteristics of the portfolio as a whole.  Gamblers often perform mental accounting in a similar fashion, believing that when they gamble money that has just been won they “are playing with the casino’s money”.  Clearly this is not the case, as every pound has the same value to an individual, regardless of its source.  This Washington Post article discusses mental accounting in the context of everyday situations.

Self-attribution Bias. This is the process of mentally taking credit for successful investment decisions while also blaming others, bad luck or exogenous events for bad decisions.  By falling prey to the self-attribution bias an investor will likely fail to properly analyse his  unsuccessful investments, preventing him from learning by experience.  All investors will make a mistake at some point in their career and those that learn from such mistakes are likely to prove better investors in the long-run.  Self-attribution bias can lead to overconfidence because the investor in question believes good results were due to his decision-making, when it may actually be due to luck.  “Managers’ Self-Serving Attribution Bias and Corporate Financial Policies” by Feng Li finds that managers of US-listed corporations are more likely to use first-person when discussing positive financial results than they are when discussing poor results, suggesting that company executives suffer from self-attribution bias.  Li also finds that companies with managers who suffer from self-attribution bias are more likely to have higher degrees of leverage and also tend to suffer from negative share price movements around acquisition announcements, suggesting those who suffer self-attribution bias also suffer from overconfidence.