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The Irrational Investor
Most modern investment analysis relies on the idea that investors are a rational bunch. However, if you talk to people about how they invest you will soon discover that most are strongly driven by a variety of emotional considerations. The exploration of the irrational investor is an ancient undertaking and is a hot area of current psychological research. In this article I explore a handful of the quirky ways that investors behave irrationally. In 1979 Kahneman and Tversky proposed something called "Prospect Theory" which attempts to explain why attitudes to potential gains and potential losses are different (See Against The Gods: The Remarkable Story of Risk by Peter Bernstein). To illustrate these different attitudes each of the following two problems was presented to separate groups of experimental subjects (group A & group B): A. In addition to whatever you own, you have been given $1000. You are now asked to decide whether to accept a sure $500 gain or take a gamble. The gamble features a 50-50 chance of winning $1000 more or nothing more.The options given to both groups have the same average result of $1500. If the experimental subjects behaved logically they should have had no particular preference for either of the choices that they were presented with. The results of the experiment were not as expected. 84% of group A opted for the sure gain and 16% went for the chance; on the other hand, 31% of group B took the sure loss and 69% the chance. These results indicate that when people are presented with gains they tend to chose the sure thing. On the other hand, when they are presented with losses they tend to take a chance. Tversky makes the following speculation about this behaviour: "Probably the most significant and pervasive characteristic of the human pleasure machine is that people are much more sensitive to negative than to positive stimuli ... [T]hink about how well you feel today, and then try to imagine how much better you could feel ... [T]here are a few things that would make you feel better, but the number of things that would make you feel worse is unbounded."In the investment world this bias may help to explain the popularity of guaranteed investments such as bonds or treasury bills despite their relatively poor historical track record (Table 1). On the other hand, it also shows that investors can be reluctant to realize a loss. This reluctance can lead to the slow accumulation of underperforming stocks in some portfolios.
One can turn the experiment around in order to make it a useful gauge of risk tolerance. Suppose that you are offered a choice between a sure gain of $500 or a 50% chance at a $1000 gain. Which of the two options you would choose? If you have a preference, ask yourself by how much the sure gain of $500 would have to be raised (or lowered) until you would have no particular preference. A risk averse individual will tend to accept a lower sure gain (perhaps $400) over the 50% chance at $1000. On the other hand, a more speculative investor will require a larger sure gain (say $600) before they would be inclined to opt for the sure thing. Although selecting a sure gain of other than $500 isn't rational it does help to quantify an investor's emotional risk tolerance. One might reasonably conclude that investors who favor the gamble over the sure thing should invest more in stocks whereas those who favor the sure thing might be more emotionally suited to bonds. I tend to think that investors should try to recognize that their first instinct might be wrong and attempt to push their behavior back in line with a rational (or at least more moderate) approach. This would mean that someone who is a risk taker might consider a larger weighting in bonds and a more risk averse investor a higher weighting in stocks. In reading this article you might have unwittingly run into another prevalent investing bias. Take another look at Table 1 and ask yourself which row of data you first found most interesting. If your eye focused on the most recent data (in the lower portion of the table) then you might be a follower of the "law of small numbers". This law refers to the tendency of many people to pay much more attention to short rather than long term performance. Unfortunately, short term performance is almost always dominated by random fluctuations and can be misleading whereas long term performance usually provides a better guide to decision making. For instance, many U.S. investors have come to expect 30% returns over the last few years which is clearly not the norm. An article on irrational investing would not be complete without mention of the recent interest in Internet related initial public offerings (IPOs) which shows all the signs of being a market bubble. Market bubbles have been around since the inception of stock markets and two classic books describe the numerous follies of the past: Joseph de la Vega's Confusións de Confusiones (1688) and Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds (1841). I will leave the humorous descriptions of the South-Sea bubble and tulip mania to these authors and concentrate on IPOs which seem to breed bubbles. IPOs are the way in which a company is first sold to the public and their number tends to grow in proportion to the strength of the latest fad (ie. electronics in the 60s, micro-electronics and biotechnology in the 80s or Internet stocks in the 90s). The bubble starts with a few hot IPOs catching the imagination of investors. Then the demand for such IPOs leads to numerous imitators and dramatic price appreciation until the public's thirst is quenched and a collapse ensues. In the 1977-1983 bubble fully 61% of all IPOs were issued near the climax in 1983. Two years later a Forbes study found that between 1975 and 1985 IPOs on average gained a paltry 3% annually vs. 14.8% for the S&P 500. Furthermore one in twenty five IPOs ended in bankruptcy, one in eight were down by 95% or more and almost 50% were down at least 50% versus the averages. Will the latest Internet craze be different? The long history of market bubbles makes it seem doubtful. For better or worse, the irrationality of investors has a long history and shows no sign of subsiding. One can hope that knowledge may armor some investors against the more obvious pitfalls. Regrettably psychological factors are very difficult to overcome and are likely to persist despite educational efforts. First published in July 1999. |
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| Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More... | |||||||||||||||||||||||||||||||||||||||||||||||||||
