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Investors Behaving Badly

Why not add 'reduce my cognitive biases when investing' to your list of New Year's resolutions?

Lee Davidson 04 January, 2012 | 0:00
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It's the New Year and time for New Year's resolutions. In keeping with the spirit, we are launching an article series today aimed at helping investors become more self-aware of the types of investing mistakes all investors are prone to make and how best to avoid them. In this series, we will be taking an introductory tour into the burgeoning field of behavioural economics and see what the growing mass of research has to say about common investing mistakes. In hope of making this series as digestible as possible, we will be publishing these in bite-sized, weekly segments with links to the longer, more detailed research articles for those interested. In our first installment, we will simply introduce the field of behavioural economics and set the stage for the rest of our discussion over the next several weeks. Without further adieu, let's begin.

The Intersection of Behavioural Biases and ETPs
In the past few years, ETPs have leapt onto investors' radar screens and into their portfolios whilst actively managed investments have begun to fall out of favour. Investors' disillusion with active managers has given rise to the growth of passive investing or 'buying the market' as opposed to trying to beat it. Propelled by this enviable tailwind, ETPs have proliferated as the passive investment vehicle of choice largely due to their tangible advantages of low costs, transparency, and liquidity. For the passive investor, this triumvirate of benefits certainly has its merits, but ETPs have benefited more than just investors' pocketbooks.

By removing a layer of active management, investors are removing from their portfolios the influence of cognitive biases associated with active management. I don't say this to disparage the actively managed fund industry. Cognitive biases are inextricably a part of human nature and cannot be eliminated. A portion of the interest in passive investing arose out of a desire to systematically reduce an investor's exposure to cognitive biases. Notice, I said 'reduce'. As an investor constructs his/her own investment portfolio, each investor is essentially their own active manager and subject to the same list of cognitive biases as anyone else. Being aware of the potential biases plaguing you as a portfolio manager should ultimately serve to make you a better steward.

Introduction to Behavioural Economics
Behavioural economics lies at the cross-roads of economics and psychology. Practitioners in this growing field have been universally lauded for their disquieting discoveries that have upended several of the assumptions underpinning neoclassical economic thought. One of these widely-held assumptions is the theory of expected utility. According to this theory, individual actors (you and me) are believed to act rationally when presented with uncertain or risky outcomes. Rational choices are simply defined as a function of the payouts meshed with the probabilities of the outcomes. Simple, correct?

For instance, if I gave you two choices: Option A says that you had a 50% chance to win £1,000 and Option B says that you have a 25% chance to win £2,000. A rational actor would be indifferent between the two scenarios because the expected payout is £500 in either scenario (0.50 x £1,000 = 0.25 x £2,000 = £500). But behavioural economists have tested the limits of expected utility theory and shown that it does not always hold true. Consider a similar scenario as before: Option A gives you a 50% chance to win £1,000 (expected payoff of £500 as before) and Option B gives you £450 with absolute certainty. The rational actor should choose Option A every time. But I, like most of you, would prefer Option B when faced with these two choices despite the fact that it has a lower expected payoff! This is one of the first biases discovered by behavioural economists and formed the foundation of Daniel Kahneman and Amos Tversky's widely-cited and revolutionary work entitled 'Prospect Theory'.

As a result of this study and ones similar to it, behavioural economists have postulated that individuals do not always exhibit rational behaviour when faced with uncertain future payoffs. Since 'uncertain future payoffs' is essentially code for 'investing', it does not take a rocket scientist to understand why having a working knowledge of these types of cognitive biases is especially relevant and useful for investors. Our task over the next several weeks is to delve into the details of some of the more relevant biases with hopes that by doing so we will be better equipped to avoid cognitive pitfalls.

Today's introduction was brief, but hopefully it whet your appetite for something more substantial. Next week, we will look at Prospect Theory in more detail and see how we can use it to make ourselves better investors in 2012.

 

Lee Davidson is a European ETF analyst with Morningstar.

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Lee Davidson  Lee Davidson is an ETF analyst with Morningstar Europe.

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