Monday Morning: Investors impaired by emotional biases

Investors are handicapped by psychological biases in their investment decisions.

As Bill Berg, president of Sigma Investment Management Co. in Portland, Ore., said in a recent speech, “Our brains are wired to make us naturally poor investors. Tell a stranger at a cocktail party that you know of a stock that just doubled, and you will find someone eager to know the name of the stock `with momentum.’

“Think how ridiculous this is … If you told someone that the price of tuna fish just doubled, they would not race to the store because tuna has `momentum.’ Our brains work correctly with tuna fish but incorrectly with stocks.”

We are poor investors because, when it comes to decisions involving significant amounts of money, we have psychological biases, beliefs and habits.

The psychological biases, which manifest themselves as automatic responses, probably evolved to help us deal with very different situations in the past.

When these shortcuts are applied automatically to investment decisions, they lead us astray.

Avoiding errors

These biases are often reinforced by beliefs and habits accumulated over a lifetime. Investors need to be aware of their psychological biases if they are to avoid expensive investing mistakes.

Financial planners and investment advisers are doubly handicapped. They must be alert to their own biases, as well as to the biases of their clients.

They must resist the impulses their own biases impose as they try to guide their clients, and they must likewise recognize and resist the impulses provoked by their clients’ biases.

As Arnold Wood, principal at Martingale Asset Management LP in Boston, says, investors need to “unfreeze the biases, beliefs and habits of the past” if they are to be successful.

Since the late 1970s, research – initially sparked by Daniel Kahneman and the late Amos Tversky but expanded upon by dozens of others – has thrown a great deal of light on how individuals actually behave in their financial decision-making.

And it has become clear that individuals are anything but rational when dealing with decisions involving potential gains or losses of money.

These researchers belong to a new field of study now known as behavioral finance.

The average investor is unlikely to read and learn from the research papers published by the behavioral finance scholars, but serious financial planners and advisers must do so if they are to serve their clients properly.

Luckily, it’s no longer necessary to painstakingly gather and read the hundreds of fascinating behavioral finance research papers that have been published since 1979.

Oxford University Press in 2002 published “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” by Hersh Shefrin. It’s a thorough and readable summary of the research of the past 24 years.

Mr. Shefrin, a professor of finance at the Leavey School of Business at Santa Clara University in California, relates the research to some of the biggest financial disasters of the 1990s, including the collapses of Barings Bank and Long-Term Capital Management LP.

In the case of Barings, trader Nick Leeson succumbed to a common unwillingness to recognize losses and the hope that if the losers were held long enough, they would get back to even.

At Long-Term Capital, the problem was overconfidence.

“Overconfidence can trump intelligence,” Mr. Shefrin says. “In the case of LTCM, overconfidence did trump intelligence.”

The experts had too much confidence in the efficiency of the capital markets and their analyses of past relationships, and placed highly leveraged bets on their analyses. When markets moved in ways not previously experienced, disaster followed.

In his book, Mr. Shefrin cautions investors against attempting to use behavioral finance insights to make a killing on the market.

While it might be possible to take advantage of behavioral errors to increase returns, the attempts introduce additional risk. Most people don’t properly account for that risk.

Advisers who want to go further after reading Mr. Shefrin’s book might consider attending a two-day seminar at Harvard University on Oct. 23 and 24 called “Behavioral Finance and Investment Decision Making.”

Two of the new behavioral finance experts, Max Bazerman and David Laibson, both of Harvard, will be among the speakers.

All advisers should become more familiar with behavioral finance research and its insights.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.