The Pitfalls of the Irrational Investor
The last year or so has drawn investor attention to the new and exciting opportunities emerging from the developing field of generative artificial intelligence (AI). Technology companies, such as Nvidia and Microsoft, make AI available for use by firms in diverse areas outside of technology, including health care, industrials, consumer products and services, and on and on. It is rational to expend effort to learn about AI to identify investing opportunities to gain exposure to a higher growth area of the global economy. The passing last week of psychologist and Nobel prize winner, Daniel Kahneman (aged 90), reminds us that investors, particularly retail investors, often make trading decisions that are systematically biased because of human nature, unbeknownst even to the investors themselves, and the effect on performance is costly indeed.
Kahneman won the Nobel prize in economics, despite being a psychologist, because his work upended the view that we can model people as essentially rational.[1] He and his frequent co-author, Amos Tversky, revealed that investors will often deviate from rational behavior because of several biases, and those deviations will adversely impact investing performance. Their work launched the field of behavioral finance, which highlights the traps into which investors can fall and the value of the financial advisor.
One aspect of Kahneman’s work concerned trading volume. Simply put, there is too much of it. Rational investors should trade when money is deposited or withdrawn, for tax management, or when new information triggers a need to rebalance. Lots of information arrives all the time, but even so, trading volume is way too high. One reason is overconfidence. Investors (mainly referring to retail investors) tend to become overconfident in the stories they tell themselves about the world and so about companies and their potential for greatness (or decline). They sell some stocks and buy others, because they are convinced that the latter will outperform the former. Many studies show, however, that retail traders trade on too many ideas and are wrong, on average, about the stocks they buy versus the stocks they sell. And not by a small amount: over a one-year horizon, the average return on the all the stocks bought is 3.3% lower than the stocks sold, and when looking at the stocks they buy shortly after a sale, those purchased underperform those sold by 5.82% after one year.[2] That’s enormous! Imagine how that would impact portfolio performance over the course of one’s investing lifetime. There are plenty of sensible retail traders out there – those who recognize that holding for the long term serves them better, but many, and especially day traders and high frequency traders, do themselves no favors by trading on so many ideas. And by the way, men tend to trade on more of their ideas than women, and since more trading leads to more underperformance, men tend to have worse investing results than women.
Kahneman also noted that people tend to be myopic and to focus more on short term gains or losses, rather than (long term) wealth. Investors also find losses more painful than the experience of a gain of the same size (this comes from evolutionary forces – it was exceedingly costly to get caught by the sabertoothed tiger, so we tend to dislike losses more than we appreciate gains). In addition, retail investors are more likely to sell stocks that are up relative to cost basis, rather than down, because they see the former as showing they have succeeded, while selling the down stocks makes them feel that they are failures. This runs counter to an optimal investing strategy: investors should not sell based on a stock’s price relative to its cost basis, but on the basis of the stock’s potential going forward. Investors also tend to extrapolate erroneously from anecdotes (and personal experience) to validate their judgments of a stock, an industry, or a company, and those extrapolations are unlikely to match the true characteristics in the data. All of these cases of “narrow framing” lead investors away from taking a full portfolio view and direct them to focus too much on individual stocks, worrying overly when one falls, and celebrating too much when one rises. Research in behavioral finance showed that such biases lead to underperformance.
More broadly, Kahneman revealed that people struggle to make rational decisions in the face of the many uncertainties in the world and in their lives. One response to this unavoidable uncertainty is for investors to try to claim greater understanding of a situation in retrospect than was actually the case. As he noted in a discussion with the BBC:
“Many people predicted the Great Recession. Many more now, than then.”
This “hindsight bias” leads to the exaggeration of the coherence and predictability of the world and instills a belief that you ought to be able to determine which stocks will do better than others. This skews investor judgment, leads them to unfounded levels of conviction, and causes them to fail to appreciate the role of diversification within a portfolio.
Biases are part of human nature and retail investors suffer because of them. Professional investors, by contrast, are incentivized to optimize whole portfolio performance, take a rigorous approach to assessing risk, and recognize that “you win some, you lose some” when it comes to individual stocks. The professional investors and the financial advisers who work directly with clients develop an investing “policy” for clients rather than making one-off, short-term decisions, and this approach helps to counter the very human biases that Kahneman and Tversky, and the behavioral economists who followed in their footsteps, revealed.
[1] Economists know people are not rational, but that modeling construct can still yield powerful insights for all sorts of economic questions, such as saving vs consumption and working vs leisure. But when there are systematic biases, such as Kahneman found in attitudes towards risk, then the model’s insights can steer us to the wrong conclusions.
[2] Odean, Terrance, 1999, “Do Investors Trade Too Much?” American Economic Review, 89(5): 1279-1298. Other studies showed similar effects of excessive trading.
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