Behavioral Finance – I’m Irrational. Are You?

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The efficient market hypothesis contends that it is not possible to consistent beat the market on a risk-adjusted basis, as overall people are rational and all of the information available is already priced in the investment values.

On the flip side, the field of behavioral finance contends that humans are inherently irrational, and we, well, do stupid things. Here’s a list of such stupid things. I don’t know about you, but I think some of them definitely apply to me.

  • People remember losing a dollar a lot more than gaining a dollar. The losses stick with you.
  • You care how much you paid for a stock, and take into account if you are gaining or losing when deciding to sell, when in reality it really shouldn’t matter. Your selling price should only matter on the fundamentals of the company.
  • People tend to buy investments when they have had a recent run of good performance. Most mutual fund purchases are made in the funds that have the best 1-year returns.
  • Overconfident investors tend to trade too much and underperform the market.

I definitely would agree that the losses stick with you. It’s the same with gambling, which is pretty close to what short-term trading is anways.

In my limited individual stock trading, I definitely do care about my original buy price. I love seeing the green Up arrows up_g.gif in my Yahoo! Finance tracker, and hate to see the red Down arrows down_r.gif in the overall Gain column. It’s true, I know it shouldn’t matter, but it does. Hmm.

So who performs the worst?

You may think that the worst investors are the more uneducated ones. Surprisingly, a study by Vanguard of their 401k account holders revealed that the worst-performing accounts belong to those people with the highest education, the highest incomes, and who rate themselves as the most skilled investors.

On other words, they think they know what they’re doing, but they don’t. That’s the worst kind of investor (and gambler!) to be. I got this tidbit from the previously-mentioned book All About Asset Allocation, but I can’t find any mention of it online.

Something to chew on.

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  1. Isn’t there a difference between “worst-performing accounts” and worst investors? Were these portfolios adjusted for risk? I’d also be interested in the time-frame of the study. I think the results would be different if it was 1996 – 2000 or 2001 – 2005.

    Also, if one was going to speculatively trade, would it be with one’s 401k? There seems to be some negative tax consequences if you have a lot of loses. I think the overall theory is sound, but the study has a lot of flaws.

  2. Eugene Franco says

    It’s true, if everyone has equivalent information access, equivalent understanding of his investment, equivalent costs, and equivalent amounts of capital to invest it is not possible to beat the market on a risk-adjusted basis.

    However there are holes in efficient market theory:
    1) Someone has to make the market efficient. For example, in my high school there were no candy vending machines and my classmates were unable to make the trip down Chambers Street to the grocery store. So, I had the members of my investing club carry boxes of assorted goodies and sell them for $1 a piece (which we had bought for $0.25-$0.33 a piece).

    On average the club made $30/member/per day, when multiplied by 10 members and 180 school days, adds up quite nicely.

    Clearly if markets had been efficient the candy need would have been met. But it wasn’t (until we made it more efficient). Furthermore, the market still wasn’t efficient, since we were making a profit (200%) far above the risk-free rate of return (5-7%).

    I’m sure that by now there are other clubs in the school who are now undercutting each other, and eventually the candy will be sold for prices marginally above the value of the students’ time to sell/acquire the candy.

    2) People are often not rational on an individual basis, but as a whole they usually act rationally through some pricing mechanism. Read The Wisdom of Crowds for more on this.

    3) Sometimes they act irrationally as a whole. Read Extraordinary Popular Delusions and the Madness of Crowds for more on this.

    4) Most importantly, people have different levels of knowledge of their investment.

    I am certain that on average MD/Ph.Ds who specialize in oncology do better at investing in the pharma and biotech industry than Joe Schmoes, even Joe Schmoes who have Ph.Ds in unrelated field (i.e. equal achievement).

    That’s because the MD/Ph.D’s have more information than Joe Schmoe.

  3. I have traded a little recently with the td ameritrade deal. I have to say I am very guilty of the first two.

    Another irrational behavior….I would bet that stock splits of high priced stocks make them more attractive to some buyers than if they didn’t have them. I know I am guilty of this. I remember last year deciding not to buy google when it was 200ish because it looked, well, “too high.” I’d bet alot of inexperienced investors do that too even if its only subconcious. Even though a split doesn’t affect any fundamentals it does change the appearance.

  4. oh yes thanks for reminding me, I mostly follow the efficient market train of thought after trying unsuccessfully to be a “day trader” due to the fact that my real job eats a lot of time already so I won’t be able to do research on specific companies all the time. I haven’t even checked my holdings for months (not that I’d trade anytime soon) but it’s probably a good time to check it out.

  5. I read somewhere that monkies were better investor than highly paid investment managers.

  6. Along the lines of JPK.

    I was watching a recent program about the shift from Pensions to 401k plans. The program mentions a large study that found that “lower end” workerd did poorly in the 401k choices and higher paid workers made much better investment decisions in their 401k’s, on average.


  7. I would bet that the lowest income quartile of workers made worse decisions than the middle quartiles (probably by not assuming enough risk in their investment decisions), but I can still believe that the top 5% or so did the absolute worst out of everyone.

  8. markets are effecient in theory but ineffiecent in practice

  9. People remember losing a dollar a lot more than gaining a dollar. The losses stick with you.

    I’m not sure that’s necessarily irrational. A dollar lost represents more than a dollar earned; a person must have earned $1.30 or so in order to have that after-tax $1 to lose.

    And if the gained dollar is a pre-tax amount, then a person may only get to keep 70 or 80 cents of it in the end.

  10. Also, when you lose a dollar, the lost dollar represents a greater share of your remaining amount than if you had gained a dollar.

    e.g., if you have $10 and lose one then while you lost 10% of your amount, the amount you lost is now 11% of the amount you have. Whereas if you gain $1 the amount you gained is only 9% of the amount you have.

    This probably also makes it seem like $1 lost is more than $1 gained (even ignoring tax considerations).

  11. Loren – I just wanted to point out that if you can deduct capital losses up to $3,000 each year as well at your marginal rate, while long-term capital gains are at 15% and short-term gains are at marginal rate.

    So as a counter to your example, with stocks, losing $1 really isn’t losing $1, it’s more like losing ~70 cents.

  12. It’s one thing to focus on your buy price when evaluating current performance. It’s another to feel the pain of red down arrows vs. the pleasure of green up ones. You SHOULD feel pain of red down arrows. It means you’re losing money. But it does not matter how much you paid in the first place. That’s a factor I’ll try to forget. Fat chance. I always want to know if it’s been a good call or a bad one. But if I would wave a want and forget what I paid for something, I’d do it. Perhaps hypnosis.

  13. RE: Stock splits

    Stock splits have the effect of making derivatives more accessible to smaller investors. To play in GOOG options will cost you 20-50k for just one contract (controlling 100 shares). High enough to keep out the small players. So yes, though stock price is meaningless from a value point of view (it’s P/E that matters), it does change the investment landscape in the derivatives market.

  14. In the main blog article, you suggested that:

    “People remember losing a dollar a lot more than gaining a dollar. The losses stick with you.”

    This is clearly not an accurate statement. The reason that people continue gambling even though they lose money overall is that they remember the sporadic wins more than the losses. That’s the reason that Las Vegas the the state lottery both stay in business.

    The same principal has been demonstrated in lab animal experiments. The infrequent random reward is more effective in stimulating a behavior than the consistent reward or the consistent punishment.

  15. Todd McFarlane says

    Thought you might enjoy this TED video that explores some of the decision making biases common to investing and being in love. Keep producing great content on behavioral finance!

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