“I can calculate the motion of heavenly bodies, but not the madness of people.”

Sir Isaac Newton’s response to the “South Sea Bubble” -- The British joint stock company, the South Sea Company, founded in 1711, was granted a monopoly to trade in Spain's South American colonies as part of a treaty during the War of Spanish Succession. In return, the company assumed the national debt England incurred during the war. Shares immediately rose to 10 times their value, speculation ran wild and all sorts of companies, some lunatic, some fraudulent or just optimistic were launched. This speculation led to a great economic bubble known as the South Sea Bubble in 1720, which caused financial ruin for many.

Behavioral Finance Overview

Behavioral finance is a field of finance that combines both behavioral and cognitive psychological theories with economics and finance. It attempts to fill the void left by studies that contradict the efficient market hypothesis or that cannot be captured in models based on perfect investor rationality.  While most economists believe in the theory of an efficient market – a market where current prices reflect all available information and all information is available to all participants at the same time – there are many instances where emotion and psychology influence people’s decision-making, causing behavior that is unpredictable or even irrational. These conventional financial theories are valid but do not account for all situations that occur in the real world of investing. By also considering behavioral finance, there can be a broader understanding of how the financial markets function.

Numerous studies have been conducted by psychologists that track factors leading to the behavioral biases that shape investors’ decision making and lead to faulty investment decisions. A great deal of academic literature is available on the subject. An extensive, yet layman’s review of these theories, can be found in this Tutorial on Behavioral Finance.

The information that follows is discusses some of the more common theories underlying behavioral finance. Not all of these theories apply to the investment process followed at Jones Villalta. However, they are included here to provide a good overview of this field of finance.

Some of the more common behavioral biases that have been applied to finance include:
Overconfidence: To have confidence in one’s abilities is a good thing. Overconfidence implies having an overly optimistic view of one’s abilities or amount of control over a situation. A study called “Behaving Badly” conducted in 2006 by James Montier found that 74% of 300 professional fund managers believed they had delivered above average job performance; the remainder thought of themselves as average. By definition, only 50% of those surveyed could have truly delivered above average work. Similarly, in 1998, a study entitled “Volume, Volatility, Price and Profit when All Traders Are Above Average” conducted by Terrence Odean found that overconfident investors trade more frequently than those who self-identify themselves as less-confident.

First and foremost, employing theory derived from the field of behavioral finance requires a fair amount of humbleness. One needs to accept that we are all, as humans, prone to the behavioral biases that cloud decision making. Intelligence, experience and demeanor do little to alter the fact that we are all too “human.” However, understanding that our decision making may be shaped and perverted by psychological biases can help us to both counteract poor decisions and take advantage of opportunities. In this respect, being irrational is not about being dumb or “crazy”. Indeed Robert Shiller described it best when he noted that it “is not the error of fools. It is more the error that afflicts some of Shakespeare’s tragic figures – in the sense of having subtle weaknesses or a partial blindness to reality.”*

Extrapolation (Non-Bayesian expectation formation): People tend to base their decisions too heavily on the most recent events or rely heavily on specific facts. Andrei Shlefier noted that “people often predict future uncertain events by taking a short history of data and asking what broader picture this history is representative of.”** It is our belief that this tendency is at the heart of almost all bubbles – in the stock market, real estate market, commodities market, in individual industries or in individual stock prices. In all of these cases, individuals (professional or layman) fail to attach reasonable probabilities to the likelihood of possible events. In most cases near-term results are weighted significantly for no reason other than that they appear foremost in the practitioner’s mind.

Over the past decade we’ve been presented with a surprising number of instances of extrapolation. During the telecommunications, media and technology bubble of the late 1990s, professional analysts constantly pointed to the near term results of companies like Cisco, Microsoft, Intel and Amazon and presumed that their near-term growth would continue unabated for a very, very long time. Similarly, in the mid to late 2000s, one could scarcely encounter a real estate agent or TV show that wouldn’t expound on the benefits of home-ownership (always citing the tendency for home prices to move up over time with little in the way of downward movements). Simply put, during good times, investors expect good times – i.e. rising markets will continue and conversely, during bad times, things will never get better.

Anchoring: Daniel Kahneman (who later won a Nobel prize for his body of work) and Amos Tversky studied this trait in the early 1970s. Subjects were asked various general knowledge questions (such as what percentage of the UN is made up of African nations), but first a wheel with the numbers one to 100 was spun in front of the subjects. The subjects were then asked if the number of African nations in the UN was higher or lower than the number on the wheel. Note: the wheel was rigged to stop on 10 or 65. The median response from the group was correlated with the higher or lower number: those that saw the spin fall to 10 had a median average of 25, while those who saw the wheel stop on 65 had a median response of 45. The study concluded that after seeing the number on the wheel, the subjects “anchored” to the number – an irrelevant figure.  Investors (professional or otherwise) anchor to current stock prices, brokerage firm analyst targets, recent rates of growth in GNP and company earnings.  While these numbers may be valid in some instances, in others they may be irrelevant.

Herd behavior: In the late 90’s, almost all investors were attracted to dotcom businesses, despite that most of them did not have financially sound business models. Compelling many investors was a sense of being left out and the reassurance they got from seeing so many other investors putting their assets into these companies. The tendency to follow the herd results in investors who are continually pursuing the next hot thing, eating up much of their profits in transaction costs.

Equity premium puzzle: Many investors become overly preoccupied by losses in relation to an equivalent gain, putting far more weight on short-term volatility in their stock portfolios. As a result, investors believe that equities must provide high-enough premiums to compensate for their risk-aversion. According to Jason Zweig in Your Money and Your Brain (New York: Simon & Schuster, 2007), “Financial losses are processed in the same area of the brain that responds to mortal danger.”

Behavioral Finance, understanding our human tendancies

We’re often surprised to find that more professional investors and business executives are not familiar with some of our more common and predictable human failings. We theorize that it is due to the subjective nature of the topic. Conclusions in finance are very much “muddied” by presuming markets are less than efficient. Due to the short time period that students spend in business school, there is simply not enough time to delve into the failings of finance. Moreover, we want corporate executives and portfolio managers that are confident in their decisions – most leaders exhibit this unfailing self-assurance. However, this does come at a price, and in certain environments this price can be very steep. Finally, we would note that this is not to say that most financial models are worthless. As Richard Thaler explains “…while the standard economics paradigm has limitations and weaknesses, there is no good substitute available.” ***

Process    

Team

*Shiller, R. 2002. “Bubbles, Human Judgment and Expert Opinion.” Financial Analysts Journal, vol. 58, no. 3 (May/June):18-26.

**Shleifer, A. 2000. Inefficient Markets: An Introduction to Behavioral Finance. New York, New York: Oxford University Press. Page 11.

***Thaler, R. 1992. The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton, New Jersey: Princeton University Press. Page 197.

Updated 12/30/09