Behaviorar Economics:
.....behavioral economics, which examines what financial decisions people make and why. This area has critical implications for investing; in fact, I believe it is far more important in determining investment success (or lack thereof) than an investor’s intellect. Buffett agrees: "Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."
Numerous studies have shown that human beings are extraordinarily irrational about money. There are many explanations why, but the one I tend to give the most weight to is that humans just aren’t "wired" properly. After all, homo sapiens have existed for approximately two million years, and those that survived tended to be the ones that evidenced herding behavior and fled at the first signs of danger—characteristics that do not lend themselves well to successful investing. In contrast, modern finance theory and capital markets have existed for only 40 years or so. Placing human history on a 24-hour scale, that’s less than two seconds. What have you learned in the past two seconds?
People make dozens of common mistakes, including:
Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient;
Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money;
Excessive aversion to loss;
Failing to recognize sunk costs;
Fear of change, resulting in an excessive bias for the status quo;
Fear of making an incorrect decision and feeling stupid;
Failing to act due to an abundance of attractive options;
Inability to assess probabilities rationally;
Ignoring important data points and focusing excessively on less important ones;
"Anchoring" on irrelevant data;
Overestimating the likelihood of certain events based on very memorable data or experiences;
After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome;
Allowing an overabundance of short-term information to cloud long-term judgments;
Drawing conclusions from a limited sample size;
Believing there are patterns when there are none;
Reluctance to admit mistakes;
Believing that their investment success is due to their wisdom rather than a rising market;
Failing to accurately assess their investment time horizon;
A tendency to seek only information that confirms their opinions or decisions;
Failing to take into account the impact of inflation;
Failing to recognize the large cumulative impact of small amounts over time;
Forgetting the powerful tendency of regression to the mean;
Creating stories that falsely link cause and effect;
Confusing familiarity with knowledge;
Inappropriate use of rules of thumb;
Overconfidence
Have you ever been guilty of any of these? I doubt anyone hasn’t.
This list will provide rich fodder for future letters, but for now, I will focus on overconfidence. In general, an abundance of confidence is a wonderful thing. It gives us higher motivation, persistence, energy and optimism, and can allow us to accomplish things that we otherwise might not have even undertaken. Confidence also contributes a great deal to happiness. As one author writes (in an example that resonated with me, given the age of my daughters), "Who wants to read their children a bedtime story whose main character is a train that says, ‘I doubt I can, I doubt I can’?"
But humans are not just robustly confident—they are wildly overconfident. Consider the following:
82% of people say they are in the top 30% of safe drivers;
Most people think they are less likely to get cancer, be hit by a bus, or get mugged than their neighbors;
86% of my Harvard Business School classmates say they are better looking than their classmates;
68% of lawyers in civil cases believe that their side will prevail;
Doctors consistently overestimate their ability to detect certain diseases (think about this one the next time you’re wondering whether to get a second opinion);
81% of new business owners think their business has at least a 70% chance of success, but only 39% thought any business like theirs would be likely to succeed;
Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days.
People were asked to answer a simple, factual question (for example, "Is Quito the capital of Ecuador?") and then to estimate the probability that their answer was correct. Regardless of the odds they estimated, they were consistently overconfident. Even in cases where they said they were 100% certain, they were right only 80% of the time.
Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1.
Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. And professional investors—so-called "experts"—are generally even more prone to overconfidence than novices because they have theories and models which they tend to overweight.
Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesn’t seem to decline over time. After all, one would think that experience would lead people to become more realistic about themselves, especially in an area such as investing, where results can be calculated precisely. Part of the explanation is that people often forget failures and, even if they don’t, tend to focus primarily on the future. But the main reason is that people generally remember past failures very differently from past successes. Successes were due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus, people believe that with a little better luck or fine-tuning, the outcome will be much better next time.
Overconfidence often leads people to:
Be badly prepared for the future. For example, 83% of parents with children under 18 said that they have a financial plan and 75% expressed confidence about their long-term financial well being. Yet fewer than half of these people were saving for their children’s education and fewer than 10% had financial plans that addressed basic issues such as investments, budgeting, insurance, savings, wills, etc.
Trade stocks excessively. In a study of 78,000 individual investors’ accounts at a large discount brokerage from 1991-1996, the average annual turnover was 80%, slightly less than the 84% average for mutual funds. The least active quintile, with average annual turnover of 1%, had 17.5% annual returns, beating the S&P, which was up 16.9% annually during this period. But the most active 20% of investors, with average annual turnover of 1,000%, had pre-tax returns of 10% annually. The authors of the study rightly conclude that "trading is hazardous to your wealth." (Incidentally, I suspect that the number of hyperactive traders has increased dramatically, given that three of the top 10 best-selling business books today are on how to day trade stocks. Also, from 1990 to 1997, the average turnover for NYSE stocks rose from 46% to 69%, and on NASDAQ, the rise was from 100% to 199%.)
Believe they can be above-average stock pickers, when there is little evidence to support this belief. The study cited above showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately two percentage points per year.
Believe they can pick mutual funds that will deliver superior future performance. The market-trailing performance of the average mutual fund is proof that most people fail in this endeavor. Worse yet, investors tend to trade in and out of mutual funds at the worst possible time, chasing performance. Consider that from 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have ended up with nearly twice as much money by simply buying the holding the average mutual fund, and nearly three times as much by buying an S&P 500 index fund. Factoring in taxes would make the differences even more dramatic. Ouch!
Have insufficiently diversified investment portfolios.
In large studies when people are asked 10 such questions, 4-6 answers are consistently outside their 90% confidence intervals, instead of the expected one of 10. Why? Because people tend to go through the mental process of, for example, guessing the weight of a 747 and moving up and down from this figure to arrive at high and low estimates. But unless they work for Boeing, their initial guess is likely to be wildly off the mark, so the adjustments need to be much bolder. Sticking close to an initial, uninformed estimate reeks of overconfidence.
In tests like this, securities analysts and money managers are among the most overconfident. I’m not surprised, given my observation that people who go into this business tend to have a very high degree of confidence. Yet ironically, for the reasons cited above, it is precisely the opposite—a great deal of humility—that is the key to investment success.
If you wish to read further on the topic of behavioral economics, I recommend the following (I have drawn on heavily on the first two in this letter):
Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich.
"What Have You Learned in the Past 2 Seconds?," paper by Michael Mauboussin, CS First Boston.
In May and June this year, David Gardner wrote four excellent columns in the Motley Fool's Rule Breaker Portfolio: The Psychology of Investing, What’s My Anchor?, Tails-Tails-Tails-Tails and The Rear-View Mirror.
There's a great article about one of the leading scholars in the field of behavioral finance, Terrance Odean (whose study I linked to above), in a recent issue of U.S. News & World Report: "Accidental Economist"
The Winner’s Curse, by Richard Thaller.
The Undiscovered Managers web site has links to the writings of Odean and many other scholars in this area.
from: Tilson Capital Partners, LLC June 30, 1999
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