Friday, June 27, 2008

How Thinking Costs You

Behavioral Economics Shows That When It Comes to Investing, People Aren't That Smart
By Michael S. Rosenwald, Washington Post Staff Writer, Sunday, May 25, 2008

Four months ago, judging myself to be the next Warren Buffett, I logged on to my Charles Schwab account and did something that in hindsight was astonishingly stupid, even for my own very long roster of financial screw-ups. I clicked over to the trading page and bought shares of Citigroup.

The company, like most of the big Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic. I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes every day. Just as soon as the banks got their write-offs out of the way, optimism would return to the sector. There would be more buyers of the stock than sellers. I would profit.

Now here I am today: My investment is down 22 percent. And I'm still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?
"You are human," said Russell Fuller, chief investment officer of Fuller & Thaler Asset Management in San Mateo, Calif. His firm uses behavioral economic theories of Nobel Prize winners and university economists to profit from the mistakes made by everyday investors and the pros on Wall Street. Humans, no matter how hard we try, act in ways that cause us to make the wrong investment decisions almost all the time.

We are -- as I was four months ago when I logged on to my Schwab account -- absurdly overconfident about what we think we know. We are -- as I am now -- reluctant to part with our losers, even though the tax code rewards us for doing so. We sell winners too soon, then we buy stocks that perform worse than the ones we sold. We get anchored on certain opinions about stocks and react too slowly to information that should change those beliefs. We believe things will happen based on how easily we can think of recent examples. (A hurricane just hit. Another one will come soon.)

The world of the behavioral economics, which melds psychology, finance and emotion, seeks to explain and sometimes exploit why we do what we do when it comes to investing. It is a field that has become more accepted lately, particularly since 2002, when Princeton University psychologist Daniel Kahneman was awarded the Nobel Prize in Economics for, as the Swedes put it, integrating "insights from psychology into economics, thereby laying the foundation for a new field of research."

Kahneman is a director at Fuller & Thaler, a firm whose other namesake is Richard Thaler, a prominent University of Chicago behavioral economist and a frequent collaborator with Kahneman. Two of the funds the firm manages that use behavioral methods have beaten Russell benchmarks from their inception through the first quarter of this year. Not surprisingly, Fuller & Thaler is not the only firm using such techniques. Firms ranging from J.P. Morgan to AllianceBernstein say they seek to capitalize on the faulty investor mind.

For instance, Fuller & Thaler likes to pay close attention to analysts who may be anchored on a stock, not raising their earnings-per-share estimates enough even though positive information has come out about the company. Fuller & Thaler's investment team pounces before the analysts realize they were wrong. As Kahneman said in an interview, "I think that betting on mistakes of people is a pretty safe bet."

Good for them. My interest in talking to the likes of Kahneman, Thaler and other behavioral economists and personal finance advisers -- besides confirming that I am not dumb -- was to understand these mistakes and what there is to do about them. "I don't think you can fix what's in your head," Thaler said. "What you can do is train yourself to say, 'This is a risky situation, and this is the kind of situation where I get fooled.' "

I asked Kahneman what fools us most frequently. That was simple, he said: overconfidence. "It's the idea that you know better than the market, which is a very strange idea," he said. "Individual investors have no business at all thinking they can do better."

Why do we? "It's because we have no way of thinking properly about what we don't know," Kahneman said. "What we do is we give weight to what we know and then we add a margin of uncertainty. You act on what you think will happen." That's what I did by buying Citigroup. But Kahneman added, "In fact, in most situations what you don't know is so overwhelmingly more important than what you do know that you have no business acting on what you know." Oops.
Barbara Warner, a financial planner with Warner Financial in Bethesda, said she sees a lot of overconfidence among two groups of people: relatively new investors to the market (me), particularly recent business school graduates (not me), and retirees (never, with my investment sense). The latter group can be exceptionally frustrating. "Now they have entirely too much time on their hands to devote to CNBC and Money magazine," she said. "People suddenly think they are smarter than they used to be because they have more time to pay attention to it."

That's a disastrous situation, Kahneman said: "The more closely you pay attention, the more you do things. And the more you do things, the worse off you will be." For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a professor at the University of California at Berkeley. Odean has written that "overconfidence gives investors the courage of their misguided convictions."

He has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, "It is expensive for these people to have ideas."

It is particularly curious when investors hold on to losing stocks, as I have done with Citigroup. This is a function of something called loss aversion, a discovery that helped Kahneman win the Nobel Prize. Thaler, Kahneman's close colleague, put it this way: "Loss aversion refers to the fact that we're wired in such a way that losing money hurts more than getting money feels good." So let's say a hundred bucks falls out of my wallet, lost forever. Under loss aversion, this hurts a lot more than it feels good to find $100 that somebody else lost.

When it comes to trading, this helps explain why we would want to hold on to losers. Selling the loser, even though it gives us a tax write-off, causes us to admit we have lost. So we do something that makes us feel better: We sell the winners. This feeds our overconfidence. But as Odean's research has shown, we often sell winners that still have some winning to do. That puts stocks with upward momentum on the market for less than they are really worth long-term, allowing savvier investors to snap them up.

"What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money," Odean said. "They create mispricings."
Along with several co-authors , he has published a somewhat depressing study about just how much wealth can be lost by everyday investors just because they trade. Looking at data from every trade made by all investors in Taiwan from 1995 to 1999, Odean discovered that the "aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points," which includes trading costs. If investors had simply bought the index and not traded at all, they would have done about 3.5 percent better. The amount of money lost was equivalent to 2.2 percent of Taiwan's gross domestic product.

So what should mere humans do about all of this?

Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors.

As for me, I'm taking some responsibility for myself, which is probably where everyone should start. Earlier this week, I logged in to my Schwab account. I sold my Citigroup shares, at a loss. I'm going to push the money into an index fund. The move felt bad, no doubt about it. I didn't fix what was in my head, but I did fix what my head had done.


Jade East said...
This comment has been removed by the author.
Jade East said...

Nice post, many of the issues raised in the article are touched on in the writings of Nassim Nicholas Taleb as well. I can recommend both his "Fooled by Randomness" and "the black swan" as great beach books.

Robert Reynolds - HMR Insurance said...

Isn't it Buffet that advocates for novice investors to only buy low-fee index fund/s and dollar cost average.

mohican said...

metaldwarf - yes - buffett highly recommends that the average investor regularly purchase index funds rather than attempt to pick stocks. I agree with him and that is all I ever do.

markoz said...

I took the Canadian Securities Course in the mid-80's. Got an excellent mark. As part of the course you were asked to analyse various stocks and pick a winner. Despite my excellent marks every single prediction I made was wrong! Mutual funds for me after that. I often wonder if this applies to me personally with respect to real estate. Every time I have considered buying (except once, 3 years before my divorce) I have shied away thinking, "Nah, too expensive. Prices are bound to come down." Well, there is wrong and really wrong and I seem to fall into the latter category. Even a broken watch is right twice a day so maybe my turn is coming...

TrueOrFalse said...

This could be about investor emotion, but in this case it is more about being uninformed. Do you really not know what is going on with the banks??

Read Mike Morgan or (think that rights).

All (pretty much) banks are INSOLVENT. Thats what happens when you run at 20 to 30 times leverage, a small setback and poof, you are gone. I know it sounds impossible, but how many years have you been walking the earth, truly conscious??

fish10 said...

Mohican - time for you to crunch the June numbers. (please)

van_coffee said...

fish10 -
I think what you mean is:

"Mohican - hope you're ok, and all is well".

When you're back, we would all be interested in your perspective.

S2 said...

Hopefully Mohican is too busy sipping fine Italian wine at the bottom of the Spanish steps to even be thinking about real estate in BC.

I think he will be pleasantly surprised when he gets back to find out all hell has broken loose.

mohican said...

I'm back from the Mayan Riviera much darker and very rested.

Jade East's comment made me rush out and buy 'The Black Swan' and get to the nicest beach I could think of!

I'll post later.