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Psychology and Behavioral Finance

"If a family member or friend who knows you well were to describe you, they would generally say you are ...”1
  1. cautious by nature
  2. a risk taker
  3. somewhere in between cautious and a risk taker

     At precisely 4am Monday morning on October 9, 2017 Richard Thaler was awoken early by a call from Sweden informing him that he had just been awarded the Nobel Prize in economics. The Nobel committee explained that Thaler's research on rationality and lack of self-control had helped us learn how these human traits affect people's individual decision making, and how they affect markets and economies. Thaler was credited with making contributions that "...built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy."2

     Thaler is a Professor at the University of Chicago’s Booth School of Business and he has published a long list of groundbreaking academic articles, as well as written several popular books. He focuses on how to get people to allocate more money in savings for their futures and his theories of auto-enrollment and auto-escalation in workplace savings accounts are increasingly being implemented. Thaler coined the term "nudging" to help people exercise better self-control for saving and in other contexts (along with Cass Sunstein, he co-authored the best-selling book Nudge: Improving Decisions About Health, Wealth and Happiness).

     Whether people will commit to saving often depends on whether they have the choice to "opt in" or "opt out” of a plan. People are more likely to save part of their paycheck if they have to opt out. Those that can't currently afford to deduct from their earnings can be nudged to commit to save if and when their income increases. In other words, when they get a raise, they would automatically have part of the money from the raise allocated to savings unless they opted out.

     Thaler's work and influence on governments and companies may have resulted in roughly $30 billion in retirement savers accounts in the last decade, according to rough estimates from fellow researcher Shlomo Benartzi. Approximately 15 million people have raised their savings rates, which Benartzi and Thaler estimate represents a fourfold increase from 2011, but others think the recent influence is much, much larger.3 Participation in 401(k)s and IRAs is optional, but as Thaler has suggested, you can nudge people and create defaults that improve investors habits and increase their odds of financial success. Generally, auto-enrollment helps individuals save, although there is some recent research finding that employees that were auto-enrolled in retirement plans end up borrowing more.4

     The general reaction in the financial media to Thaler's winning the Nobel Prize was that it was both predictable and easy to explain. Thaler was not the creator of the field of behavioral finance, but he was one of the most important contributors as it moved from a fringe category of economics to its current position as a mainstream element. Fifteen years earlier, Daniel Khaneman won the Nobel Prize in economics for his pioneering work describing "Prospect Theory" (originally published in 1979 with the late Amos Tversky). Ironically, Khaneman points out that he is a psychologist that never took an economics class. In 2013 Robert Shiller was also awarded the Nobel Prize primarily for his conclusion that markets are inefficient and for his elaboration on how "Animal Spirits" impact people and economies. Thaler was the first economist to reach out to Kahneman and Tversky in the mid-1970s, according to colleague Hersh Shefrin.5

     Shefrin worked extensively with Thaler as the field was beginning and they linked “self control” back to Adam Smith. Shefrin has authored several books including Beyond Greed and Fear and more recently Behavioral Risk Management in which he argues that the most important risk management disasters in recent years all have psychological pitfalls at their root. Shefrin notes that Adam Smith and John Maynard Keynes were behavioral economists before the actual field developed.

     Roger Lowenstein summarized that Tversky and Kahneman were the first to document systematic irrational behaviors, but Thaler’s lasting accomplishment was to pull these realizations out of psychology, where they were regarded as interesting quirks, into economics, where they spawned a new discipline, behavioral economics.6

     Michael Lewis summarized at "…in the late 1960s, they [Tversky and Kahneman] had set off to confirm their suspicion that the weird self-defeating stuff that people do isn't random and inexplicable but fundamental to human nature. More to the point, human beings were not just occasionally irrational, but systematically irrational. They had predictable biases -- for instance, they were inclined to draw radical conclusions from tiny amounts of information. Their preferences were unstable. When faced with a choice between two things, they responded not to the things themselves but to descriptions of those things. Perhaps most significantly, people responded very differently when a choice was framed as a loss than when it was framed as a gain. Tell a person that he had a 95 percent chance of surviving some medical procedure and he was far more likely to submit to it than if you told him he had a 5 percent chance of dying." Thaler "took their work, and championed them, and created an entire field."7

     Jason Zweig at the Wall Street Journal summarized how Thaler “produced a series of brilliant and startlingly funny articles published in prestigious academic journals beginning in the early 1980s, he pointed out that ‘only economists think that people think the way economists think they think.’ Instead, non-economists think like human beings: impatiently, inconsistently, easily distracted by irrelevant factors." Zweig added Thaler told him in 1996, “what investors fear even more than losing money is having to say ‘What an idiot I am.’”8

     There doesn't seem to be a consensus on who first used the phrase "you never get a second chance to make a first impression" but we know it was used in an advertising campaign in 1966. While the recent acceptance of behavioral finance in economics is part of the reason why this chapter precedes discussions of specific investments and the finance industry, I also discuss it first because everyone has biases and prior experiences that affect how they react to new information. You may not be able to change a first impression, but you can consciously decide to think and research before taking actions. Understanding how your positive and negative experiences, inclinations, and biases could impact your financial decision making can be critical.

     I have a practice of asking clients if they've had any major successes or nightmares with their finances. Those experiences are often important factors in influencing financial decision making and implementing a financial plan. Investors that have had bad experiences with specific investments can be particularly sensitive.

     People’s responses to questions and surveys can also be affected by the environment and method of questioning. Responses to the same question asked on a paper form or via computer may differ from responses when done face to face. A 2014 Harris Poll for TradeKing Advisors found that more than half of would-be investors say the prospect of speaking to an in-person financial advisor has actually stopped them from investing (one reason being reluctance to share their financial position and limited financial knowledge).9

     Some may feel embarrassed or defensive with many questions, so I will apologize in advance if I offend anyone with anything in this book. I try to use descriptions used by the field's pioneers and experts rather than my own terminology for many of the less than flattering descriptions of people’s decision making.

     The seemingly countless examples of irrational behavior and repeated errors in judgment have been documented in an expanding list of academic studies. Peter Bernstein wrote decades ago in Against The Gods that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty." In other words, we often make illogical decisions and one of the reasons is we are often biased, or prejudiced against specific ideas and theories.

     The fields of "behavioral finance" and "behavioral economics" have evolved in recent decades attempting to better understand and explain how emotions and cognitive errors influence investors, the decision-making process, markets, and the economy. Many researchers argue the study of psychology and other social sciences sheds considerable light on the efficiency of financial markets, as well as explain many market bubbles, crashes, and stock market anomalies. As an example, some believe that the past outperformance of value investing resulted from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks (more on these subjects later). Shefrin suggested investor preferences impact asset pricing in his 2005 book A Behavioral Approach to Asset Pricing. Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.

     Tversky and Kahneman started documenting common human errors that typically result from biases and simple rules (heuristics) that people tend to use in making decisions. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain. They also found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Some researchers have also found that people are willing to take more risks to avoid losses than to realize gains, but others have conducted studies that implied loss aversion does not exist in some scenarios. Faced with sure gain, many investors are risk-averse, but faced with sure loss, many investors become risk-takers.

     Another behavior commonly mentioned in investing is known as "fear of regret." People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the IRS, accountants, and others may also contribute to the tendency not to sell losing investments.

     Terrance Odean has also done fascinating work on some of these topics and published several groundbreaking articles documented results obtained from actual brokerage accounts. One of his articles titled "Are Investors Reluctant to Realize Their Losses?" was published in the October 1998 issue of the Journal of Finance and he has also written extensively on the differences between male and female investors, why investors trade excessively, and other related topics.

     Dan Arieli is the author of the best seller Predictably Irrational, in which he pointed out that not only do people make irrational decisions, they will do it regularly and we can often predict the behavior in advance. Yet, Professor Khaneman wrote in Thinking Fast and Slow, "’Irrational’ is a strong word, which connotes impulsivity, emotionality, and a stubborn resistance to reasonable argument. I often cringe when my work with Amos is credited with demonstrating that human choices are irrational, when in fact our research only showed that humans are not well described by the rational-agent model. Although humans are not irrational, they often need help to make more accurate judgements and better decisions, and in some cases policies and institutions can provide that help."

     Meir Statman suggested in his 2017 book Finance for Normal People that we have moved to the point wherein investor behavior is considered normal rather than rational, or irrational. Statman suggests our common hopes (avoiding poverty, nurturing our children and families, being true to our values), along with our dreams (gaining high social status and achieving wealth), and tendency to engage in games and risk taking, are all regular and expected behaviors.

     Arieli summarizes that anchoring is also prevalent, whereby, if you consider how much you should pay for a house, you will be influenced by the asking price. When asked to price a home, real estate agents and business students are affected by price lists although interestingly the business students generally admitted they were influenced, while the agents did not. Owners of homes who have a high reference point (and thus face higher losses) set a higher price, spend a longer time trying to sell their home, and eventually receive more money (if they do eventually sell).

"Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds. Investments are a game to many of us, like tennis. We may not admit it, and we may not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed. And investments are about what we do with the money we make and how it makes us feel. Investments are about a sense of security in retirement, the hope of riches, joy and pride of raising our children, and paying for the college education of our grandchildren."
     Meir Statman in What Investors Really Want

     Statman has also written extensively about overconfidence, which most researchers believe causes more trading than is reasonable, particularly when the markets are performing well. He writes, "stockbrokers and stock exchanges have good reasons to promote unrealistic optimism because unrealistically optimistic investors trade more often that realistic ones, adding more to the revenues and profits of brokers and exchanges. High stock returns boost the optimism of investors, prompting them to trade, while losses dampen optimism and the desire to trade. Stock trading increases following stock market gains, as optimism inflates, and stock trading decreases following stock market loses, as optimism deflates. This is true in the United States and in 45 other countries where it has been studied, ranging from Australia to Venezuela."10

     People are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge. However, increasing levels of confidence usually show no correlation with greater success. For instance, studies show that men consistently overestimate their own abilities in many areas including athletic skills, abilities as a leader, and ability to get along with others. Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market, however, most fail to do so.

     People often see other people's decisions as the result of disposition, but they see their own choices as rational. Investors frequently trade on information they believe to be superior and relevant, when in fact it is not and is fully discounted by the market. This results in frequent trading and consistently high volumes in financial markets that many researchers find puzzling. On one side of each speculative trade is a participant who believes he or she has superior information and on the other side is another participant who believes his or her information is superior. Yet they can't both be right.

     Some researchers theorize that investors follow the crowd and conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down. Additionally, many believe that money managers and advisors favor well known and popular companies because they are less likely to be fired if they underperform.

     People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. As an example, Professor Shiller found that at the peak of the Japanese market, 14% of Japanese investors expected a crash, but after it did crash, 32% expected a crash.11 Statman noted that at the stock market high of February 2000, individual investors surveyed by Gallup expected, on average, that the stock market would deliver a 13.3% return in following 12 months, but they expected their own portfolios to deliver 15.5%. In Feb 2002, investors expected the stock market to return 8.9% for next 12 months, while their portfolios would return 9.7.12 Some believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.

     People often see order where it does not exist and interpret accidental success to be the result of skill. Tversky and many others have extensively debated the topic of whether there is a "hot hand" in basketball. Specifically, the question is whether a player that has made several shots in a row is more or less likely to make the next shot. Many are surprised to learn that there is substantial evidence that the hot hand may be a fallacy (many argue the probability isn't substantially greater that a player on a streak is more likely than usual to make the next shot). There is an ongoing debate on the topic, but the main point is there is clear evidence that recent experience usually biases expectations and investors should consider that carefully.

     Gur Huberman found that investors strongly favor investing in local companies that they are familiar with. Specifically investors were far more likely to own their local regional Bell Company, rather than the other regional Bells. The study provided evidence that investors prefer local or familiar stocks even though there may be no rational reason to prefer the local stock over other comparable stocks that the investor is unfamiliar with.

     Many researchers theorize that the tendency to gamble and assume unnecessary risks is a basic human trait. Entertainment and ego appear to be some of the motivations for people's tendency to speculate. People also tend to remember successes, but not their failures, thereby unjustifiably increasing their confidence. As John Allen Paulos wrote in his book Innumeracy, "There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful."

     People's decisions are often affected by how problems are "framed" and by irrelevant but comparable options. In one frequently cited example, an individual is offered a set amount of cash or a cross pen, in which case most choose the cash. However, if offered the pen, the cash, or an inferior pen, more will choose the cross pen. Sales professionals typically attempt to capitalize on this behavior by offering an inferior option simply to make the primary option appear more attractive.

     In one experiment, participants were either handed a card, or asked to select a card. Those that selected a card were less interested in selling the card back and required more than four times the price to sell the card as compared with the participants who were handed a card. Similarly, many researchers believe that analysts who visit a company develop more confidence in their stock picking skill, although there is little evidence to support that confidence.

     Supermarket shoppers offered a sales promotion of 10% off on cans of soup bought twice as many cans on days when the shelf sign said "Limit of 12 per person" than on days when the sign said "No limit per person." Rationally, pricing gas with an extra .9 cents makes little sense, but it obviously would hurt sales to price in full cents. Similarly 99 cents stores obviously found a niche (not a secret by any means, but still not rational on a pure pricing basis) where sales are substantially higher at just under a $1 then if they priced everything in round dollars.

     The dynamics of the investment process, culture, and the relationship between investors and their advisors can also significantly impact the decision-making process and resulting investment performance. Full service brokers and advisors are often hired despite the likelihood that they will underperform the market. Researchers theorize that an explanation for this behavior is that they play the role of scapegoat. In Fortune and Folly: The Wealth and Power of Institutional Investing, William O'Barr and John Conley concluded that officers of large pension plans hired investment managers for no other reason than to provide someone else to take the blame and that the officers were motivated by culture, diffusion of responsibility, and blame deflection in forming and implementing their investment strategy. The theory is that they can protect their own jobs by risking the manager’s account. If the account underperforms, it is the manager’s fault and they can be fired, but if they outperform, they can both take credit.

     Psychological and aggressiveness characteristics are particularly relevant to each individual investor's strategy and risk tolerance. For instance, women tend to be more risk averse than men. Passive investors have typically become wealthy without much risk, while active investors have typically become wealthy by earning it themselves and taking significant risks. Some investors are more adventurous and willing to try new strategies and investments, while others are more conservative and prefer to stay with investments that they have experience with. Some dream of being celebrities and like to invest where the action is, which can make them easy prey for fast-talking advisors.

     In additional to the extensive research and commentary relative to financial markets and economics, there have also been fascinating studies and research related to how people think and act regarding nonfinancial (but not necessarily completely unrelated) topics, like politics and religion. Just as investment professionals can differ in their belief regarding superior strategies, we often see similar polarization in politics and religious beliefs.

     Narratives and metaphors tend to resonate with people and can be useful for investors to keep in mind. Jonathan Haidt (author of The Righteous Mind) summarizes "The human mind is a story processor, not a logic processor. Everyone loves a good story; every culture bathes its children in stories." Haidt uses the metaphor of the elephant and the rider. The elephant is our heart, or gut feeling, while the rider is our mind or logical controller. Haidt further describes how people tend to make decisions first on intuition and then to seek evidence to corroborate or rationalize their actions or arguments. Whether a specific investment "feels" right or wrong can be inconsistent with whether it has a reasonable probability of success and whether it makes sense as part of your portfolio and financial plan.

     Khaneman's Thinking Fast and Slow focuses on how making well thought out decisions, rather than instinctive or quick conclusions, is often the best choice. In investing, taking a long-term rather than short-term perspective and approach can be critical.

     Arieli's focus goes far beyond finance in discussing psychology and its effect on broader topics.

"These biased processes are in fact a major source of escalation in almost every conflict, whether Israeli-Palestinian, American-Iraqi, Serbian-Croatian, or Indian-Pakistani. In all these conflicts, individuals from both sides can read similar history books and even have the same facts taught to them, yet it is very unusual to find individuals who would agree about who started the conflict, who is to blame, who should make the next concession, etc. In such matters, our investment in our beliefs is much stronger than any affiliation to sports teams, and so we hold on to these beliefs tenaciously. Thus the likelihood of agreement about ‘the facts’ becomes smaller and smaller as personal investment in the problem grows. This is clearly disturbing. We like to think that sitting at the same table together will help us hammer out our differences and that concessions will soon follow. But history has shown us that this is an unlikely outcome; and now we know the reason for this catastrophic failure."

Later, in chapter 27, I will summarize my research on opinions about the causes of the global financial crisis, which is particularly relevant to Arieli's conclusions.

     Haidt summarized in a 2012 interview "Our minds evolved not just to help us find the truth about how things work ... in the social world our minds are not designed to figure out who really did what to whom. They are finely tuned navigational machines to work through a complicated social network in which you've got to maintain your alliances and your reputation. And as Machiavelli told us long ago it matters far more what people think of you than what the reality is, and we are experts at manipulating our self-presentation. We're so good at it that we actually believe the nonsense that we say to other people."13

     Haidt explains "If you ask people to believe something that violates their intuitions, they will devote their efforts to finding an escape hatch-a reason to doubt your argument or conclusion. They will almost always succeed."

     Psychotherapist Shimon Kessin has a somewhat different view and argues that adults often react and make decisions as if they were still children. Some people make childish decisions only occasionally, while others act like children more often (depending on the circumstance). Some make snap judgements, while others are less emotional. Financial decisions can be heavily influenced by greed and fear and few, myself included, can completely wipe out instinct and emotion. In fact, my wife frequently tells people I am just a big kid, to which I generally agree in many social circumstances, especially when it involves other actual kids. But in dealing with money and finances, decades of personal experience, working with others, and studying history has taught me to keep a long-term perspective and to look for opportunities over time.

     Some people have good instincts and have a history of making successful financial decisions. But most of us make decisions at some point that in hindsight may not have been so smart, or may have been too risky. The number of studies documenting completely illogical results is sobering. Your instinct and beliefs can literally cause you to discount facts and probabilities, come to incorrect or illogical conclusions, and do things that are harmful to your financial health.

     Investing involves projecting into the future and there are many unknowns. There are also almost always multiple major and minor factors that affect investment results. So it’s important to understand how much unpredictability there is. But at the same time we can take actions to attempt to minimize risks and improve the probability of reaching our goals.

     Having been exposed to the lessons of behavioral finance, hopefully most investors can proceed with a long-term perspective. After reviewing the literature on overconfidence, hopefully we can be humble and realistic in our expectations (especially if you are a male). Keeping the history of herding and fads in mind, hopefully we can avoid the temptation to participate in future illogical crazes that are unsustainable. As we move into dealing with the investment business and the process of investing, hopefully we can approach them with an open and unbiased mind.

"Only two things are infinite, the universe and human stupidity, and I'm not sure about the former."
Attributed to Albert Einstein

Notes - The Footnotes in the Book are sequential and for this chapter start at #59 and end at #71.

1. This question is attributed to according to Liz Moyer, Putting Robo Advisers to the Test, Wall Street Journal, April 24, 2015
5. (12 October 2017)
7. (5/29/2015)
10. See also for additional research on this topic.
11. Wall Street Journal, June 13, 1997
12. Meir Statman in What Investors Really Want (Page 44)
13. (6 minutes into video)

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Table of Contents and Launch Site

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