I’m an engineer by background and most everyone who works with me knows me as a rationalist: someone who embraces the theory that when we are presented with a variety of options, we will choose the option that both maximizes our individual satisfaction and falls in line with our long-term goals.
But, as 30 years either trading, investing or overseeing trading desks taught me, being a rationalist does not automatically make one rational. In fact, I have bought on upward momentum, added to a sliding position, doubled down when the slide became a crash, and cried for the IMF, the Fed, or another deity to come to the rescue more times than I care to remember.
Now, as an adviser, I enjoy the luxury of perspective and rely on behavioral economics to identify the biases that cause traders and investors to perform below their full potential. Ironically, behavioral economics is such anathema to rationalists like me that Nobel laureate Daniel Kahneman was famously motivated to state: “it seems that traditional economics and behavioral economics are describing two different species.”
My observation is that traders’ and investors’ biases can be generally clustered around five broad areas:
While investors in hard-to-mark securities, like private equity, can arguably mark-to-model their way out of this one bias, they are susceptible to the trappings of the remaining four, since the value of private equity securities can be (imperfectly) hedged, the securities can be sold on one of the now-proliferating secondary platforms, or losses assumed through the inherent dilution from the failure to participate in a misguided investment’s capital increases.
1) The Need for Anchors
When confronted with decisions, it is human nature to begin with the familiar and use it to make judgments. Kahneman and Tversky ran an experiment where they used a wheel of fortune with numbers from 1 to 100 to illustrate this point. With a group of subjects, they spun the wheel to get a number and then asked the subjects numerical questions about obscure percentages like the percentage of ancient Egyptians who ate meat, for instance. The subjects would have to guess whether the right answer was higher or lower than the number on the wheel and then provide an estimate of the actual number. Kahneman and Tversky found that the answer given by subjects was consistently influenced by the outcome of the wheel spin. Thus, if the number on the wheel was 10, the answer was more likely to be 15 or 20%, whereas if the number on the wheel was 60, it was more likely to be 45 or 50%.Market prices provide a similar anchor with traded assets and an investor asked to estimate the value of a security is likely to be influenced by the market price, with the value increasing as the market price rises (and vice-versa).
2) The Power of the Story
For better or worse, human actions tend to be based not on quantitative factors but on storytelling. People tend to look for simple reasons for their decisions and will often base their decision on whether these reasons exist. In a study of this phenomenon, Shafir, Simonson and Tversky gave subjects a choice on which parent they would choose for sole custody of a child. One parent was described as average in every aspect of behavior and standing whereas the other was described more completely with both positive (very close relationship with child, above-average income) and negative characteristics (health problems, travels a lot). Of the subjects studied, 64% picked the second. Another group of subjects was given the same choice but asked which one they would deny custody to. That group also picked the second parent.While the results seem inconsistent, they suggest that investors are more comfortable with investment decisions that can be justified with a strong story than one without.
3) Overconfidence and Intuitive Thinking
We humans tend to be opinionated about things we are not well informed about and to make decisions based upon these opinions. Fischhhof, Slovic and Lichtenstein generalized the finding by asking people factual questions and found that people gave an answer and consistently overestimated the probability that they are right. In fact, they were right only about 80% of the time that they thought they were. What are the sources of this overconfidence? One might just be evolutionary. That confidence, often in the face of poor odds, may have been what allowed us to survive and dominate as a species. The other may be more psychological. Human beings seem to have a propensity to hindsight bias, i.e., we observe what happens and act as it we knew it was coming all along.Thus, there are investors who claim to have seen the 2008 crash coming during earlier years, though nothing in their behavior suggests that they did (the only one who cogently documented its advent was my friend Nouriel Roubini, not an investor).