If you can keep your head when all about you are losing theirs… Yours is the earth and everything that’s in it… – Rudyard Kipling from his poem If
In his classic book The Four Pillars of Investing, William Bernstein wrote, “The major premise of economics is that investors are rational and will always behave in their own self-interest. There’s only one problem. It isn’t true. Investors, like everyone else, are most often the hapless captives of human nature.”
Until fairly recently most people believed the “rational man” theory of economics was true; or at least mostly true. The story of its downfall, and the birth of a new field known as behavioral finance, is an interesting and important one for investors.
Tversky, Kahneman, and the Birth of Behavioral Finance
As humans we are very good at spotting irrational behavior in others and equally talented at being blind to our own illogical decisions. We have always known irrational behavior existed but we thought it was an aberration. We believed most people were every bit as rationale and logical as we assumed ourselves to be.
This façade of rationality began to crumble with the collaboration of Israeli psychologists Amos Tversky and Daniel Kahneman in 1968. Tversky and Kahneman were both smart and talented, but perhaps the most important characteristic they shared was self-awareness. Each of them had the rare ability to see themselves accurately and to admit their own weaknesses and mistakes.
Therefore, when they decided to study errors in human judgment and decision making they looked first to themselves for research material. Indeed, they decided early on not to study any errors in human judgment unless they first detected the problem in themselves. Kahneman later said, “People thought we were studying stupidity, but we were not. We were studying ourselves.”
This approach gave them a unique perspective. Instead of assuming that irrationality was an aberration existing in others they tried to identify it in themselves. If they each made similar errors they thought there was a good chance many others did as well, so they designed experiments to find out. In this way they proved that irrationality in human behavior was not isolated, but widespread.
If the irrationality Tversky and Kahneman documented was random their discoveries would have been mildly amusing, but not very useful. Instead, they discovered that many of our errors in judgment are systematic. When placed in certain situations a large majority of us make the same mistakes over and over.
It’s almost like we are hardwired to make certain mistakes with our money. Indeed, as Bernstein stated earlier, we often appear to be nothing more than “hapless captives of human nature.” But does it have to be this way?
Another well-known behavior psychologist, Daniel Ariely, argues that we are not just irrational, but Predictably Irrational. In fact, he has written a best-selling book with that title. And therein lies the usefulness of the field of behavioral economics. If we can learn to predict when we are likely to be irrational, then we also have a chance to prevent at least some of the mistakes we are prone to make.
Legendary investor and author Kenneth Fisher puts it another way. In his book The Only Three Questions that Count, Fisher states that to be a successful investor you need to constantly ask yourself, “What the heck is my brain doing to blindside me now?” To answer that question you need to be familiar with some of the fascinating findings of behavioral economics, which will be the focus of my next several posts.
As for the collaboration of Tversky and Kahneman, their groundbreaking research lead to the Nobel Prize in Economics for Kahneman in 2002. Unfortunately, Amos Tversky died in 1996 or he would undoubtedly have shared in the award. And it all started with their ability to recognize, admit, and try to explain their own irrational behavior.
Principle
Our investment behavior is predictably irrational. Because our irrationality is predictable, it is also preventable. The field of behavioral finance studies the irrationality of our decisions regarding money and helps us answer the vital question, “What the heck is my brain doing to blindside me now?”
Application
How much does irrational decision making hurt investors? Research firm DALBAR, Inc. has been trying to answer that question for the past 20 years. DALBAR reports that from 1993 to 2013 the S&P 500 returned 9.22% annually, but the average investor in stock mutual funds only earned 5.02%, a difference of 4.20%. However, it is difficult to determine how much of this 4.20% gap is due to irrational investor behavior (buying high and selling low) and how much is due to other factors.
Many experts believe the DALBAR study overestimates the cost of irrational behavior but few would argue with the idea that irrational behavior harms returns. After 20 years of study DALBAR’s conclusion, as stated in its 2014 report, is that “Investment results are more dependent on investor behavior than on fund performance.”
Even if we cut the results of the DALBAR study in half irrational behavior is still costing investors 2 percentage points of return a year, or 22% of the returns available by simply buying and holding an S&P 500 index fund (2% / 9.22% = 22%). Assuming an initial investment of $10,000 an annual return of 9.22% would grow to $52,774 after 20 years, while a return of 7.22% would only grow to $32,193, a difference of over $20,000. That is definitely enough to make the study of behavioral finance well worth your time.
Application
Make the study of behavioral finance part of your financial education. Not only will it save you money, it is also fascinating.
For a short introduction I recommend The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy, by James Montier. If you find this interesting and want to dive in deeper try Your Money and Your Brain, by Jason Zweig, or Thinking Fast and Slow, by Daniel Kahneman, one of the founders of the field of behavioral finance.