Behavioral Finance: Are We Hard-Wired for Failure?

The findings of behavioral finance can make us feel that as investors we are doomed to fail. But human beings aren't automatons—we can become more self-aware and learn from our mistakes. This portion of the chapter briefly discusses some common behavioral failures and what we might do about them.⁹

We don't have to observe investor behavior for very long before concluding that human beings are hard-wired for investment failure. Large fortunes tend to disappear entirely in three generations. During bull markets investors lose all sense of perspective and load up on increasingly risky equities, as though prices could never go down. During bear markets investors give in to despair, selling out near the bottom, apparently convinced that equity prices are going to zero. Investors chase returns, piling into whatever sector or manager is hot, ignoring research showing that return-chasing behavior always ends in tears.

There is even an entire field of study—behavioral finance—devoted to the detailed analysis of how and why investors fail. Exotic-sounding concepts like “loss aversion” are really just academic jargon for investor behavior we see every day. These so-called “cognitive biases” lead us to behave in ways that are irrational, that is, that lead us into taking actions that are against our own interests.

It's very important for investors to recognize that we are optimized for wealth destruction, especially at inflection points in the capital markets (bull and bear markets). In effect, we seem condemned to own exactly the wrong portfolios at the peak of bull markets (i.e., too many stocks) and at the nadir of bear markets (not enough stocks).

The sequence of investor behavior always (always!) follows this pattern: As prices rise, investors enter a period of overconfidence, allowing equity exposures to exceed prudent levels. As more and more investors pile into the markets and brag about their great returns, “herding” behavior causes investors to own even more equities, as there now appears to be safety in numbers. Then, as prices begin to fall and wealth destruction takes hold, investors panic—at first individually and then, again, as a herd. Prices fall further and further and investors proceed to immortalize their losses by selling out.

Compounding this first round of wealth destruction is the next step in the pattern, where risk-seeking behavior has atrophied completely. Hapless investors, now sitting firmly on the sidelines (in cash), watch helplessly as the portfolios they used to own rebound powerfully. By the end of this cycle, capital has been destroyed on a massive basis.

Professor Odean on Behavioral-Inspired Wealth Transfer

Professor Terry Odean teaches at the Haas Business School at Berkeley. No one on the planet has studied individual investor behavior more closely than Odean, and what he has to say isn't pretty.

According to Odean, when an individual investor sells stock A and buys stock B, stock A outperforms stock B by (on average) 3.4 percent. In other words, the more stock ideas an individual investor has, the poorer he gets.¹⁰

And because there is always someone on the other side of these trades (institutional investors), individual investors are effecting a massive transfer of wealth from families to institutions. Odean and his colleagues once tracked every sale and purchase made on the Taiwan stock exchange for a year. Their conclusion was that every year, individual investors transferred an amount equal to 2 percent of the entire value of the Taiwan stock exchange to institutional investors.¹¹

What Can We Do about It?

What is it about human beings, who in other aspects of their lives are capable of making rational decisions, that causes such wealth-destroying behavior? John Maynard Keynes once remarked that “markets are almost, but not quite, rational.” True enough. But human investors are also almost, but not quite, rational. To be successful as investors we can't allow our emotions to dictate our actions. But this is very, very hard to do.

Here, for example, is how investors should behave: When stocks are cheap—near the bottom of bear markets—we would be near the top of our target equity range. When stocks are expensive—near the top of bull markets—we would be near the bottom of our range. When everyone else is buying, we would be sellers; when everyone else is selling, we would be buyers.

But ask yourself, is this the behavior you observe in other investors? Is it the behavior you observe in yourself? Of course not. If anything, we tend to do exactly the opposite. Human beings are rational, but not always: Our decision making is clouded and corrupted by our emotions. And the more powerful those emotions are—and greed and fear are right up there at the top of the heap—the worse our decision making will be. We are optimized for wealth destruction.

But all isn't entirely lost. There are steps thoughtful investors can take to minimize the likelihood of irrational action and to blunt its consequences. Michael Pompian's recent book addresses these very issues and is well worth looking into for investors who find their behavior chronically undermining their returns:¹²

• First, recognize the problem: Because we are emotional as well as rational creatures, we are prone to acting emotionally precisely when we should be acting rationally.
• Next, buy the right risk and keep it: If our comfort level suggests putting 65 percent of our assets in stocks, what in the world are we doing allowing that percentage to grow to 80 percent in a bull market or 40 percent in a bear market?
• Swim with a buddy: Find a friend, family member, or trusted advisor—someone whose money it isn't—who will watch your back, playing Devil's Advocate and holding you accountable for the emotional factors at play in your investment thinking and decision making.
• Study the past: Becoming familiar with the aftermath of bull and bear markets in the past will go a long way toward avoiding the “it's different this time” mentality.
• Own flight-to-quality assets: If you are spending 3 percent of your capital every year, consider setting aside 9 percent to 10 percent of the portfolio in laddered Treasuries. In a catastrophic bear market, you will have three years of spending in quality assets and at very little opportunity cost.
• Develop a crisis-management program: Decide now, while you are calm, exactly what you will do during the next period of market stress, whether that stress comes in the form of a bear or bull market. Write the program down, as well as the rationale for it. This step can help avoid the consequences of greed and fear, as well as avoiding troublesome behavioral responses such as framing, anchoring, and counterfactual thinking.

Before you know it, you'll be looking forward to the next market crisis!