InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
OCTOBER 3, 2018
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
We have regularly discussed The Economy, investment markets, and asset management in IntelDigest, and will continue to do so in the future. In this issue, however, we’ll turn away from the numbers, and present some information on the Psychology of Investing.
We will turn back to an update of the market trends and numbers next week.
Kahneman and Tversky
A great deal has been written in recent years about the collaboration of two Israeli psychologists, Daniel Kahneman and Amos Tversky. They met in 1968 when both were professors at Hebrew University … Tversky working as a “mathematical psychologist” applying formal models to characterize human behavior, while Kahneman was doing groundbreaking work on judgment and decision-making. This would form the core of their joint and collaborative work from 1968 until Tversky’s death in 1996. They came to define the areas of behavioral economics and human rationality.
Their influence on the fields of psychology and economics have been immense, but they also have had significant impact on the fields of social science, law, medicine, and business.
Much of their work applies directly to the behavior of investors. It appears that the human brain is not a rational economic actor … when faced with uncertainty, even the best investing minds may throw good money after bad, sell at the first sign of trouble, or make a variety of muddled financial decisions.
So, we will devote this issue of IntelDigest to an exploration of psychological biases involved in investor decision-making.
The aim of Behavioral Economics is to mitigate the effects of common flaws in decision-making by heightening our awareness of our own foibles. Common biases include:
Anchoring
Many investors fail to reexamine their holdings when problems arise with an investment. Instead, one may hold a stock, hoping that it will reach a value which the investor has predetermined as the target price, such as the price that he or she paid for it, or a previous high. This is a behavioral bias known as anchoring.
Being wed to a particular number can weigh down one’s judgment, even when it is clear that the price to which one is anchored is irrelevant to the decision at hand.
Hindsight Bias
Hindsight Bias is a failure of logic, where investors may immediately recall their winning moves in the stock market, while conveniently forgetting investments where they made the wrong call.
The typical investor misremembers his/her bad moves, which blocks one from achieving honest assessments of performance.
Endowment Effect
Every position in one’s portfolio should be subject to regular reassessment. However, in practice, we often overvalue things simply because we already own them … a bias called the endowment effect.
All investors should be able to ask themselves if the reasons that they bought particular investments are still valid. If not, there are surely better deals In the marketplace; investors simply have to be willing to let go of what they already own.
Choice Overload
Sometime called “analysis paralysis,” choice overload refers to an investor’s inability to decide on an investment move because of the vast number of choices available in the markets.
Recency Bias
Recency Bias is a predisposition to give added weight to recent events. For example, if the market has been going up recently, investors tend to assume that gains will continue, even if a rational analysis would indicate otherwise. Similarly, a recent correction makes investors fear that there is more to come.
In reality, long-term financial trends are historically more reliable than near-term events. The most reliable long-term trend is a “reversion to the mean.” Note that it took only 19 trading days after the 9/11 attacks for the markets to return to pre-September 11 levels.
Loss Aversion
An investor should feel as much pain from a 10% loss as pleasure from a 10% gain, but researchers have concluded that the pain of loss is roughly twice as powerful, psychologically, as the pleasure from an equivalent gain. This is referred to as loss aversion.
Confirmation Bias
Decision-making is subject to confirmation bias … an unconscious tendency to gravitate toward evidence that supports what we already believe. For example, an investor who is heavily invested in technology stocks will be biased in favor of that sector. The better move, however, is to always challenge our predispositions … one can reap more rewards with a more honest analysis.
Confirmation bias is among the more pernicious of our behavioral biases, central to political polarization, as well as overconcentration in a particular asset class.
Availability Bias
Company fundamentals are a more reliable barometer of a stock’s potential performance than the 24/7 news cycle. But, humans often judge probabilities based on how easily-corroborating information comes to mind. This is availability bias. A compelling TV appearance by a CEO can crowd out other pertinent information which has a greater bearing on the company performance and stock price.
Counteracting Behavioral Biases
Investors must make themselves Aware of these biases, work to take a more Objective approach to their holdings, focus on Fundamentals, and Review performance regularly.
Keep records of your trades, including the rationale for purchasing each investment. By evaluating regularly, you can determine if an investment is underperforming its benchmarks, or no longer appropriate to your strategy.