Behavioral Finance and Behavioral Investing
Behavioral finance studies how to systematically take advantage of errors caused by human thinking and emotion. Behavioral investing, on the other hand, aims to cash in on the irrational investor. How is behavioral finance different from behavioral investing?
- Behavioral Finance studies the interaction between finances and human psychology. It is, in essence, the study of heuristics and biases and why they cause misbehavior. It is the successor of modern portfolio theory, as we learned that neither the markets nor individual investors are genuinely rational. Behavioral finance is a sub-field of behavioral economics.
- Behavioral Investing, then, attempts to use behavioral finance to find and utilize inefficiencies in the market caused by emotional miscues. Questions to consider here: how do you measure the effects of heuristics and biases in prices, and how do you take advantage of them? An irrational investor does not understand behavioral finances.
Don’t be an irrational investor! But learn the truth—we all are!
So, how can you understand Behavioral Finance and thus profit from Behavioral Investing? Start with this: know that you, too, have the same biases and behavioral glitches as everyone else. Right?
Just like how people are different when it comes to losing weight.
Weight Loss and Behavioral Finance/Investing
Think about weight issues in modern society for a second. Everyone knows that you can eat less, exercise more, and thus obtain an ideal weight. Knowledge is not enough. That is like knowledge of Behavioral Finance.
Actually losing weight is behavioral investing. If we conceive how complicated weight is, we begin to understand why it is so easy to lose money.
Just like not everyone is cut out for losing weight, not everyone should be interested in behavioral investing, either.
Behavioral investing is a style of investing that stems from an age-old battle in investment theory. The fundamental question: are investors mostly rational or irrational?
If they are irrational, then can you develop an investment thesis that profits from the irrational (and thus unpredictable) behavior? For example, are there predictable pricing distortions in the market due to investors’ emotional errors? Or, since they are irrational, do errant emotional responses not provide actionable investment theses?
Rational or irrational, this battle pits traditional modern portfolio theory (which argues that the market and individuals are rational) against behavioral finance (which argues that investors have inherent biases). Can either make you money?
Let’s look at behavioral investing and try to find “behavioral alpha;” that is, excessive returns derived from understanding people’s cognitive biases.
Understanding Behavioral Investing: The Central Thesis
The central thesis of behavioral investing is that to outperform the market average, you must understand behavioral finance. If people are irrational, which leads to price inefficiencies, how do you take advantage of the inefficiencies to improve investment performance?
The keys to the central thesis of behavioral investing:
- How can you measure the price distortions caused by behavioral errors?
- Once measured, can you consistently take advantage of them?
Before answering those key questions, let’s review traditional investment theory: modern portfolio therapy. From there, we can understand the age-old battle and the evolution of behavioral investing.
Modern Portfolio Theory and Bubbles
Modern portfolio theory (MPT) became standard investing theory by 1980. At its core, there is the assumption that markets and people are rational. The theory is useful because it clearly defines inputs and allows modeling based upon these rational (linear and non-adaptive) inputs. Markets are efficient, and people respond rationally to them.
Slowly at first, folks noticed that MPT could not model the foibles of the stock market of the 80s and 90s. Thus over time, Behavioral Finance is born. [Nod to Kahneman and, of course, Richard Thaler (of Nudge fame)]
The damning truth is that MPT cannot explain bubbles, momentum investing, actual investor returns, or any number of phenomena seen in the stock market. Neurologist-turned finance guru William Bernstein decimates MPT in his books, but see especially his most recent book The Delusion of Crowds: Why People Go Mad in Groups.
QED: how are bubbles rational?
MPT remains necessary to model rational behaviors, but behavioral finance fills in the many gaps. The market is a complex, non-linear, and adaptive system better explained by behavioral Finance than MPT.
This is not just about just being contrarian—behavioral finance helps define herd mentality and why shortcuts in thinking (heuristics) and emotions (biases) cause assets to be mispriced
The explanatory power is strong—in theory—but can you profit from it?
Overconfidence Bias and Behavioral Finance
Overconfidence bias looms large in behavioral finance. Among the most common way to shoot yourself in the foot, overconfidence is prevalent and pervasive.
What is overconfidence bias, and what are some examples of overconfidence bias in behavioral finance?
What is Overconfidence Bias?
Most consider themselves above-average drivers.
Overconfidence is the source of our enhanced driving abilities; it is the human tendency to overprize our talents and intelligence.
As a bias, of course, none of us will admit overconfidence. But, like other biases, it is easy to see in others and difficult to see in ourselves.
The opposite of overconfidence bias in behavioral economics is multimodal. First, one could have actual competence issues which prevent investing. Next is the Dunning-Kruger effect, discussed below. Finally, you have the person who is competent to make initial investment decisions but is just unable to, for reasons of self-esteem or self-confidence.
Overconfidence can be broken down into different types:
Types of Overconfidence
- Overrating yourself: this is our above-average-driver
- Assumption of prediction abilities: you predict something that you have no control over
- Unrealistic optimism: the belief that everting’s coming out roses.
The American Psychological Association defines overconfidence as
a cognitive bias characterized by an overestimation of one’s actual ability to perform a task successfully, by a belief that one’s performance is better than that of others, or by excessive certainty in the accuracy of one’s beliefs.
It is good to be self-confident but balance a truthful self-concept.
Let’s now look at some examples of overconfidence bias in action.
Three Examples of Overconfidence Bias in Behavioral Finance
Overconfidence Example: Why Women are Better Investors
Women, on average, are better investors than the alternative. This is example one of an overconfidence bias in behavioral finance.
It is relatively straightforward to study that women are better at investing than men (you look at geometric returns and the sex of the account owner). Indeed, more complicated is understanding why women make better investors than men.
The data are not a slam dunk that there is female alpha. Some studies clearly show superior returns from female account owners (up to 1% a year), while others do not.
Regardless, folks have a consensus that women are better at investing. If that is the case—why?
Here is a list of what makes women better investors:
- More risk-averse
- Better self-control
- Trade less frequently
- Less overconfident
- Better educated
- Follow advice
- Better savors
- Less prone to selling during volatility
Let’s dig into a few of those further.
Women are More Risk-Averse
Is this such a bad thing? Women have less risk-seeking behavior than men do. This is a “just-so” story from the evolutionary perspective but can still be seen in many facets of modern-day life.
Avoiding excessive risk is a good thing!
Women are less overconfident than men. While this is related to being more risk-averse, there are important considerations.
First off, the implication (which is true) is that men are overconfident. As far as behavioral biases go, one of the most devastating biases is over overconfidence.
The stock market is full of overconfidence. Whenever you make a trade, you are betting that a stock will do something, but the person on the opposite side of the transaction is betting that the stock will do the exact opposite! So every time you do something in investing, you are betting that you are more intelligent than the other guy.
If women trade less often, they know it is because they are not more intelligent than the other guy! Same thing with an aversion to risk, better self-control, and not selling during a panic.
Women can be downright self-deprecating when it comes to investing. But is that expressed self-confidence necessary? No! What you say about your confidence level is not essential; it is what you do about it.
Don’t ask a woman if she is confident about her competence; watch how she behaves when making investing decisions. From a behavioral investing standpoint, women get invested, stay invested, and keep an appropriate level of risk—all big wins.
Just as impostor syndrome is more common in women, the Dunning-Kruger effect is more common in men.
Remember, while everyone thinks they are an above-average driver, most also think they are a below-average juggler.
Self-reported competence has everything to do with how difficult the task is. The easier the task, the more people who think they are above average at the task. The more complex the task, the more people believe they are underaverage.
For men with the Dunning-Kruger effect, one hopes that they realize that being good at something is more complex the better you get with time.
For women, more often than not, they have Imposter Syndrome rather than Dunning-Kruger. With Imposter syndrome—everyone would have difficulty with the task, but women tend to underplace themselves and think they cannot do it as well as others. Any capable person struggles with a difficult task.
So while men are overconfident with easy tasks, women tend to underplace themselves, especially with complex tasks (like investing).
Overconfidence is pernicious and an error of commission. But, on the other hand, Underplacement is more minor and one of omission.
If you are optimistic that you will be a good investor (vs. pessimistic), you don’t perform any better! Competence is essential in determining the outcome, regardless if you are over-or under-confident.
Women are underconfident compared to men but are more competent investors. The female alpha is alive and well, and all investors can learn from successful women investors.
Stock picking, market timing, economic forecasting… etc……….… all show little to no ability to be done better than average. All are, however, staples of discussion regarding performance on the stock market. Strutting like a peacock means that you are overconfident, not competent. No one can be competent with these chaos-based indicators leaving less overconfident women as better investors.
Overconfidence Example: Why Doctors Shouldn’t Invest in the Healthcare Sector
Why Doctors Shouldn’t Invest in the Healthcare Sector is the second example of overconfidence bias. Because you work in healthcare, does that mean you know more about investing in healthcare than the average investor?
We all have biases. A common bias for doctors: the brighter you are, believe it or not, the more likely you are susceptible to these biases and not know it.
I see many physicians who are overweight in the healthcare sector or buy individual stocks in the industry. Because we know a product or use a drug, we feel like we have more information than the market.
Understand that the information we think we are privy to is already priced. We are not more intelligent than the market. We do not have a unique insight into the healthcare industry because we work in it.
Rather than overweight the healthcare sector, doctors should actually underweight the healthcare industry. When you lose your job, it will most likely be due to a down-turn in the sector, and you won’t lose twice (your income and your investments). The whole sector will go in and out with the tides. That is, the contagion will take down your industry and the entire sector. Don’t let that happen at the worst time when you have also lost your job due to the same contagion.
Don’t fall prey to overconfidence bias! Underweight the healthcare sector if your paycheck also depends on the sector. And please don’t pick individual equities because you feel you have inside knowledge. You don’t.
Overconfidence Example: Generalized Financial Advice
Our final example of the overconfidence bias comes from reliance on others. I have said that you cannot depend too much on an advisor. So, here is the retirement mistake: generalized retirement advice.
Generalized retirement advice can be too hot, too cold, or just right, like the porridge in the Goldilocks fable.
You get one shot at retirement. Is that generalized retirement advice the retirement mistake of a lifetime? How do you know if it is just right for you?
Let’s look at overconfidence in the generalized financial advice relm.
Overconfidence in Retirement Advice
At a bare minimum, retirement advice must account for fundedness and risk tolerance.
(The Retirement Mistake)
Look at the figure above to understand overconfidence in generalized advice. On the left is income level (or total asset amount/fundedness for retirement), and on top risk level (or risk tolerance).
Regarding retirement income, when you listen to generalized retirement advice, it may not apply to you because of your level of fundedness or your level of risk.
As for risk, a “100% equity asset allocation” might be good advice for a youngster willing to take on short-term market risk. Conversely, it is horrible advice if someone commits the cardinal sin of investing and sells low, even once in their lifetime. Only when you bake in the appropriate level of risk is the advice correct. Too much or too little risk, and the recommendation is wrong.
As for the level of fundedness, advice is not the same for those who have undersaved as for those who have oversaved. If you have undersaved, the best thing to do is to plan for social security. On the other hand, if you have oversaved, the retirement risks are different for you.
The advisor who gives generalized advice suffers from overconfidence bias as no one person finds that generalized advice of use. Yet we all offer advice!
So, what happens when the well-funded listen to generalized retirement advice?
How can generalized retirement advice provide you with the answers? Unfortunately, it can’t, and listening to all the talking heads (including those on the internet with blogs) is a retirement mistake born from overconfidence bias.
Advice is intended for a person with a specific income and risk level. You are not that person. Remember particular facts and circumstances. Don’t take advice from advice-givers.
Unless it is “Just Right” for your fundedness and risk level, it is lousy advice.
Choose your advice carefully. Facts and circumstances make all the difference with overconfidence bias.
Summary: Overconfidence Bias Behavioral Finance
So, there are some examples of overconfidence bias in behavioral finance.
The first example demonstrates that women have less overconfidence bias than men. It is key to understanding the etiquette of investing. Since most of the time, the correct answer is to “do nothing,” possessing a healthy skepticism to change is good.
Next, I pick on doctors’ proclivity to think their insights apply to similar areas because they understand one field well. Again, doctors are a classic example of the overconfidence bias writ large.
Finally, we discuss overconfidence when taking advice. Who understands your fundedness and risk tolerance and can give you sensible advice?
These examples of overconfidence bias in action show how prevalent and pervasive the issue is. Unfortunately, we all suffer from overconfidence bias, especially if we think we are intelligent.
As a result, there are typical problems seen as a result of overconfidence bias:
- Thinking you are not overconfident
- Overestimating what we can do
- Underestimating how long something will take
- Having a baseline of skill that diminishes continuous learning
We all remain susceptible to overconfidence bias in behavioral finance. Unfortunately, despite knowing we are overconfident, it is a complex problem to fix.
How can you make money from understanding your overconfidence bias?
Who Shouldn’t be a Behavioral Investor
Not everyone is cut out to be a behavioral investor.
What kind of investor are you? First, let’s group investors by type and then attempt to understand some basic heuristics and biases.
Let’s look at growth investing, value investing, dividend investing, MPT investing, and finally, behavioral investing:
- Growth Investing: the truth is, 4% of stocks drive all of the return of the index (the other 96% return, on average, is the same as the risk-free rate). Stock pickers think that they can outperform the index by finding these needles in the haystack. For those who understand the evidence-based idea that the market gets the median return, for most picking stocks is a fool’s errand. Not everyone is above average.
- Value Investing: You try to buy low and sell high (or never sell). Stocks can be cheap because they deserve to be or because they are a diamond in the rough. To have an advantage, you need to know the future or figure out which details matter in a financial statement. Nothing the DIY investor cares to do…
- Dividend Investing: perhaps the worst of both worlds, dividend investors believe that income is the answer. The short of the matter is dividend stocks are a non-optimal and tax-inefficient way to invest.
- MPT Investing: buy-and-hold the efficient frontier. This can get average returns, which is a great goal for DIY investors. If you can invest tax-efficiently and with low fees, your average returns will put you in the top quartile decade after decade.
- Behavioral Investing: the most difficult to do, you need to understand where others fail and, more importantly, how you can take advantage of the irrational behavior. All while understanding and battling your heuristics and biases.
As a DIY investor drawn to complexity (see Rick Ferri’s Evolution of an Index Investor), I still think it is possible to do better than the market (which is described better by chaos theory than current models). Not by picking growth or value stocks, and not by picking trends or sectors, but by understanding my weaknesses. There are many!
As humans, recency and overconfidence bias are firmly entrenched after a decade-plus bull market. Who has actually lost money in the last decade? Well, anyone not 100% invested in the S&P 500.
More critical than resulting and relying on what worked in the past (because it only works well until it stops working well), it is knowing your thesis for the next 5 or 10 years. Care to predict the future?
I predict that people will still have heuristics and biases 5 or 10 years from now.
So now, how do I profit from that prediction?
Behavioral Alpha—Investors (including you) will continue to have biases in the future
So, I hope you understand the theory—the one thing that won’t change—that people are irrational. Therefore, markets are made of people and are also irrational.
Behavioral investing attempts to identify measurable and persistent distortions in the prices. These data are derived empirically. From the data, what strategy can you use to take advantage of other people’s irrationality?
Understand there is positive behavioral alpha to be found if you reject MPT and use behavioral finance as the underpinning of your long-term portfolio. Separate your long-term portfolio (via mental accounting) and ignore volatility! Risk is not volatility; it is not meeting your investment goals.
Summary—Behavioral Finance and Behavioral Investing
In Summary, there is behavioral alpha in the market. Both negative (chasing returns, worrying about volatility in long-term portfolios) and positive (understanding and meeting your long-term goals).
You can look for it in the investment to select (behavioral investing), the funds that you don’t pick (those active funds that will likely underperform indexes), and also in you.
Yes, you are irrational, too. You have heuristics and biases, but honestly, it is easier to see them in others than it is to see them in ourselves. Remember, you can be an excellent DIY Physician investor!
That people are—and will remain—irrational seems to be a given. Given that irrational is unpredictable, positive behavioral alpha is hard to come by.
One way to profit is to wall off your long-term investments and don’t concern yourself with short-term volatility. Easier said than done?
So, can a DIY investor use behavioral investing to meet long-term goals? Yes! It is as easy as losing weight.