Investor behaviour is as influenced by psychological factors of exuberance or caution than by a company’s fundamentals. Catherine Lafferty tries to get inside investors’ heads to find out why they invest the way that they do.
In 1879, celebrated American artist William Holbrook Beard painted what would be his most enduring work, The Bulls and Bears in the Market. The painting depicted a mêlée between bulls and bears outside the New York Stock Exchange. In lavish oils, the throng of quadrupeds are shown in a heated outdoor clash. Some bulls are in full-throated cry and others are in determined charge; a huddle of bears appears to be in urgent conference while another has been hurled skywards. The scene is full of furious movement in contrast to the serenity of the handsome Grecian buildings surrounding it.
The work helped to lay the foundation of the enduring mythos of the investor and their psyche. The words bullish and bearish entered the lexicon as adjectives describing the stereotypical characteristics of investors and markets, bullish investors charging together in testosterone fuelled excitement as markets rise, bearish ones move with pessimistic caution as market curves swoop downwards.
Yet that which was once the domain of art and cinema, with films like Wall Street embedding the image of aggressive braggarts riding market waves in public consciousness, has increasingly become subjected to the quantitative analysis of social scientists. Behavioural economics has now gone mainstream, with Richard Thaler the latest to win a Nobel Memorial Prize for his work on the subject. The mysteries of the investor’s psyche are gradually being revealed.
One of the first comforting myths about investment to fall to the unforgiving examinations of social scientists is that it is a discipline conducted on a rational basis. The truth is very different; investment decision-making is riddled with cognitive and behavioural biases.
“There are systematic biases in investor behaviour,” Professor David de Meza of the London School of Economics says, noting that men are more likely to be active in buying and selling stocks than women.
Some of the most important of the string of biases to which researchers say investors are prone include confirmation bias, in which facts may be subconsciously picked or emphasised to fit a pre-existing conclusion, and the endowment effect, in which people tend to believe that things they hold are valuable, leading to an overvaluing of investments. There are also illusions of control and hindsight biases in which people find themselves wise after an event. This fits in neatly with confirmation bias and means that people tend to remember their successes but forget their failures, thereby reinforcing their preferences.
It could be tempting to downplay or dismiss the role of psychological biases among investors, as of marginal significance in the grand scheme of things but there is agreement by industry participants and academics alike that cognitive biases can cause asset managers to lose money.
Charles Cresteil, investment specialist at BNP Paribas Asset Management, cites biases and irrationality by investors as one of the reasons for inefficiencies in the market. In particular, he highlights short-termism and lack of portfolio diversification as irrational behaviours militating against investment success.
“It is difficult to avoid your biases even if you are aware of them, Cresteil says, adding: “It’s what I call the escalator effect. When you see an escalator which is out of order, even if you prepare your brain to the fact it won’t work, after your first step on it your brain is always ready for it to move.”
He stresses that investors should be aware of their biases as a first step and then they can find the tools to help them get around and possibly even benefit from their cognitive biases.
The overconfidence of investors is a bias to which behavioural economists and psychologists return time and again. Think of the blind, charging conceit of a raging bull, impervious to the wiser counsel of more timid creatures urging it to slow down and think again. It might be a snapshot of the emotions and behaviours displayed in the market.
Constantinos Antoniou, associate professor of finance & behavioural science at Warwick Business School, explains how overconfidence can be manifested in investment decisionmaking. “People either just trade too much or respond to news or rumours that don’t have investment value,” he says.
The overconfidence effect may well be intensified in the market by the demographic make-up of its participants, with evidence showing a greater propensity to overconfidence among men than women, and that single men trade more aggressively than women or married men.
But differences between male and female investment behaviour should not be overstated, Antoniou stresses.
“The male/female difference is the main distinction among people but it is a weak distinction; the variation of these biases in the population is not that big,” Antoniou notes.
Yet that such differences exist between men and women could be seen as complementary, particularly in a group, or institutional investment context.
Professor Nigel Nicholson of London Business School believes that an asset management industry more equally balanced between men and women could make for more fruitful discussions and active processes before decisions are made.
People invest money to make more money and yet their avarice can be counter-productive to their aims. Consider another common bias, a difference in attitude to investments in which people have made money compared to those which have made losses. But the difference in attitude is the opposite to what would be expected.
Researchers have found that there is an asymmetry in how people behave when they make losses compared with when they make gains and that people displaying a strange attachment to their loss-making stocks.
“What tends to happen is that people are quicker to sell their winning stocks and less willing to sell the losing stocks with assymetries in how people perceive gains from losses,” Antoniou says, adding: “This can be costly for investors as they are reluctant to write off their losses so that they could reduce their tax bill.”
Another common bias shows the importance of memory in the human psyche with personal experiences influencing the way investors think about assets.
Antoniou explains: “So let’s say you start participating in the stock market in a period the stock market is doing better, then I will be more open to investing in equities, compared to someone that just happened to be engaged in equities at a period when the market wasn’t doing so well.”
The bias is at odds with the most basic of investment mantras, that past performance is no guide to future performance. For all its repetition, the mantra’s effects may be all but negated by the mental forcefield of positive or negative memories.
Professor Nigel Nicholson, business psychologist at London Business School, is in no doubt that biases engrained in the mind are stronger than the brain’s ability to reason.
“Loss aversion is important – as Jimmy Connors once said people hate to lose more than they love to win – this leads people often to sell too early and to chase losses,” Nicholson says.
Loss aversion, that inability to relinquish possession of an asset no matter how its value seems to be draining away and unlikely it is to produce returns seems to be a trait so hardwired in the human brain that it can derail another trait that humans have to varying degrees but must be a key item in the investment armoury, the ability to take risks.
“On the trading floor you have to train traders how to lose money because otherwise they start making bad decisions and won’t take the right risks. That’s one of the most important biases,” Nicholson says.
As if all that weren’t enough, humans are also hampered in their investment decision-making by superficiality in their analysis. This tendency not to look far beneath the surface is more expensive for investors than they realise. Constantinos Antoniou calls this a shrouded attribute.
“Another bias that I would say is costly is people are not very good at analysing things that are below the surface,” he says.
“The first order stuff people process but second order information people are not so good at processing.”
People also seem to dislike ambiguity. Research by Antoniou has found that as analyst forecasts for smaller companies are relatively more ambiguous; they are priced pessimistically by investors wary of conflicting information.
While people may be superficial thinkers, their emotions seem to have powerful effects on their decision-making. A study by Antoniou compared the forecasts of analysts who were in close proximity to a terrorist attack with analysts who were elsewhere. The study showed that analysts in the attack zone produced more negative predictions than their counterparts. The pessimistic effect lasted for about 30 days.
The effect is stronger when the analyst is closer to the event and located in a low-crime region, he found. Affected analysts were also relatively more pessimistic around the one- and twoyear anniversaries of the attacks. The findings indicated that exposure to extreme negative events affects the behaviour of information intermediaries and the information dissemination process in financial markets.
Humans are not especially solitary creatures; investing, like so many other activities, can be conducted in a collective as well as an individual capacity. Groups are psychologically important to humans and a place in which humans do much of their learning. Yet here again, institutional investors being a collective will have the advantages – and disadvantages – of group psychology.
Nicholson contends that groups are not good at making decisions because they can let their psychology overcome their rationality.
“If you look at groups like juries and the way they make decisions you will see that if they are disciplined, a group can be good because then you get more information in the room than any individual can have, you could avoid errors and be alert to things, but unfortunately that’s not how it goes,” he adds.
There are a range of reasons people organise themselves into groups, including a desire for recognition and esteem. More altruistically, they also want to contribute to a common good. But when a person ventures an opinion in a group setting they may find it harder to row back from it and change their mind. “As soon as I say I prefer the red to the green and you say I agree, I’m stuck. It’s harder to retreat once you’ve got that group psychology working,” Nicholson says.
He adds that a typical error made in groups is when people pat themselves on the back if they’ve made a decision efficiently, whereas speed and efficiency might not be good practices for groups, which may need more time to deliberate than they give themselves. “We congratulate ourselves often on efficiency criteria when actually we should be congratulating ourselves on effectiveness criteria,” he notes.
A common handicap from which groups may suffer, that of uniformity of thinking, can be directed by the uniformity of their make-up, with boards often being “stuffed full” of likeminded people, according to Nicholson.
“There’s a not so distant history of company decision-making showing how so-called independent directors don’t do their job and are not so much of a canary in the mine, frankly, not blowing the whistle when they should. They want to be liked and valued and they’re being paid anyway so they want to help the company and helping means not making trouble,” he observes.
Group chairs often want to be well liked and avuncular, Nicholson says, whereas what is really needed is an effective chairperson who will make sure contrarian voices are heard, presumptions are challenged and not give anybody an easy ride.
Although groups of individuals can in theory add up to more than the sum of their parts, with different and complementary strengths working together harmoniously the cognitive and emotional biases experienced by individuals can also be magnified in a group setting.
Professor David de Meza points out that one of the weaknesses of investment groups is that understandably no one is willing to be the person identified as making an investment mistake. This makes for herd behaviour which leads to instability.
“People think trends will continue, excessively buying things that have risen in the past and excessively selling things that have fallen in the past,” he says. “This exaggerates trends and can lead to dysfunction in the market.”
Researchers speculate that if a person perceives themselves to be similar to those around them they may be more likely to agree with the other members of the group and less likely to challenge them. The antidote to such uniformity and herd like behaviour is diversity.
“What you really want is psychological diversity; you don’t want people who have the same history,” Nicholson remarks.
Yet this inevitably poses a problem for asset managers, who tend to use similar recruitment methods and hence by accident or design, recruit people from similar backgrounds and with similar attributes.
“Do recruiters choose the same old kinds of people?” Nicholson asks. “I think they do. The same sort of people apply and on it goes. Does that reinforce or continue the psychological biases in investment? I think so, yes. To have somebody different in the room who is going to challenge accepted wisdom is unlikely in some of these contexts.”
As behavioural economics moves into the mainstream the asset management industry has started to take notice. Fund managers have an obvious interest in discerning whether the market is mispricing things so they can better identity the prize assets for which they search. The insights of behavioural ideas are relevant to what they do, hence an increasing number of fund managers have behavioural teams tasked with measuring and helping to iron out their biases.
Part of the problem which the asset management industry needs to grapple with is that humans must work at being rational.
Experts say that in our natural environment humans are not good at probabilistic thinking. Rather we are much better at categorical thinking: we like saying whether things are good or bad and making quick decisions.
If there are significant conditions of uncertainty, we congratulate ourselves to build up our confidence so we can go into battle and take risks. The psychology we have is one that suits us well to a hunter gatherer lifestyle but less so to a modern investment lifestyle.
Nicholson recommends that for institutional investors and asset managers to turn themselves into dispassionate, evidence-based machines, training in behavioural and personality psychology should be standard in asset management.
The point of the training would be to give the individual a more complex view of the world and how decisions are made. People should be taught how decisions are made, how bad decisions are made and vigilance profiles should be built in against those biases, he insists.
In group investment decision-making, people should be told at the beginning to park their previous positions and be openminded; value people who change their minds, Nicholson stresses. The person who should be congratulated is the person who shifted their position the most in light of the evidence collected by others in the room.
“You need to use the group to your advantage by using a dynamic that allows people to learn and not get anchored on their positions,” Nicholson says.
He adds that in order to correct for herd behaviour, asset managers should build a culture around investment that involves rational scrutiny and doesn’t over-value the individual stars. Cognisance of the pitfalls of psychology on investment decision-making could explain an apparent scepticism among researchers about the skills of asset managers, especially those deploying active investment strategies. Does active management of investment portfolios make any difference to returns or is it no more effective than, say, basing decisions on the movement of the stars in the firmament? Antoniou says the evidence is equivocal.
“The evidence is that on average actively managed funds do not outperform enough to cover their fees,” he adds. “But there are papers which show there are skills in certain situations between some funds and some conditions. It is an active area of research and it is a debatable idea, so there is evidence on both sides as to whether they add value or not.”
Tellingly perhaps, Antoniou does not put his personal investments into actively managed funds. He is not convinced that they add value and thinks investing in passively managed vehicles like exchange-traded funds and market tracking products are a better option.
The mystique of asset management may crumble as the assault on its hitherto hidden psychological biases behind investment decision making are increasingly being revealed.
Nicholson admits that he is cynical about the way people make judgements and decisions in financial services and feels that asset managers are too inclined to congratulate themselves for successes that may not be wholly attributable to their investment abilities. “Asset management is an industry that is just floating on inflated values; asset managers sit around congratulating themselves on good decisions when random stockpicking would work just as well,” he adds.
One point is clear. An investor’s psyche plays a role in their decision-making and may be more influential than anything they have learnt in a lecture hall. Self-awareness and manging their impulses when faced with a decision are skills that could mean the difference between a successful investment strategy or not.