“Markets can remain irrational longer than you can remain solvent,” said John Keynes.
Investing in the capital markets is a prospective activity, the main objective of which is to maximise capital preservation and utility of the outcomes. One should be aware of the systematic cognitive and emotional weaknesses of investors so as to recognise particular environment when a mistake is highly likely to happen.
Judgements of people and investors, about external appearances and fundamental risk, could be systematically wrong in many ways. Such systematic errors of judgement are called biases. Behavioural finance theorists argue that well-known market anomalies (such as value, momentum, low volatility) still exist because of such behavioural biases.
It is important to note that such biases are highly persistent in a volatile and complex environment that forces the decision-maker to act quickly and rely on intuition. Many professionals rely on their intuition in extreme scenarios when decisions must be made quickly, but only some of them are more likely to be misled by their intuition.
Two prominent researchers, Daniel Kahneman and Gary Klein (some concepts covered in ‘Thinking, fast and slow’), argued in favour of intuition until they found that surrounding environments play a far greater role than previously realised.
This is the tendency to assign a very narrow interval to confidence intervals of uncertain outcomes and/or shifting the mean of the distribution.
This may sound like a lofty definition, but this particular behavioural bias can be boiled down to 3 possible outcomes. First, the real outcome is outside of the confidence interval. Second, the real outcome is inside of the confidence interval. Lastly, the complete distribution is usually shifted to the left.
In general, investors overestimate their ability to value companies, predict earnings and growth potential. This triggers over-reaction (over-weighting) to stocks that one is optimistic about and under-reaction (under-weighting) to stocks that one is pessimistic about.
If an investor has a very narrow confidence interval, it implies that there is a large likelihood that the real outcome will be a surprise. A large body of studies document that CFOs of leading US companies are miscalibrated and choose very narrow intervals when it comes to the performance of the S&P 500 index.
Duke University researchers collected more than 11,000 such forecasts and (perhaps surprisingly) the correlation between their response and the true value was slightly above zero. These are the financial officers of leading corporations, who are among the top-earners in the country, and even they are uncertain of the prospects of the S&P500, and thus the risk their own company faces.
Such a miscalibration is persistent among small retail investors as well. In his book ‘Black Swan‘ (the title is a reference to a totally unforeseeable event), Nassim Taleb goes further into detail about how an inadequate perception of risk leads individuals to take risks they must avoid. So, how can one partially protect against this?
Firstly, one should not let oneself be confident about one’s investment opportunities. Give three reasons why not to follow an investment idea. If done diligently, this exercise brings the opposite view on the table.
Next, when examining historical data one should not focus primarily on the upside potential. Protecting the downside risk by evaluating past failures of similar investment opportunities is crucial. Usually, focusing on stock price decreases and explaining the environment in which it happened and what triggered it is helpful when trying to see the complete picture. The triggering events could be similar, but under different economic environments, companies react differently.
Additionally, as people usually are more likely to remember their “good” investments, research indicates that keeping a list of previous failures is helpful.
This is the tendency to buy financial assets that are currently popular within the society (e.g. assets with huge media coverage). In general, people are wired to focus on what they know and neglect what they do not know.
Moreover, the role of luck is paramount. This inattention to important information makes investors overconfident about beliefs. In general, behavioural biases are interconnected, and multiple biases could influence a person simultaneously.
Research shows that investors spend more time researching stocks they have heard of or those that have grabbed their attention recently. Retail investors are influenced by media coverage, but also the professional fund managers that they look to for guidance and research.
The information is not always relevant to the fundamentals of a company but nevertheless triggers excessive trading volume, which in return reduces the overall return of investors. Humans are wired to make decisions that are satisfactory rather than the most efficient, because of their inability to consider all relevant information.
Mitigating Attention Bias
Therefore, it is wise to attempt to process information more efficiently and consider a wider range of investment opportunities. The following are some ways to go about doing this.
First, filter the media that impacts the decision-making process and use it only as one bit of information among many. This might sound redundant, but with the development of “fake news”, there are an increasing number of outlets, which cover events extremely negatively or artificially portray others as glowing positives.
Additionally, answering “who possesses this information?” may be helpful. If it is already published in a media outlet most likely, it is incorporated in the price, and one runs the risk of buying high. This is so obvious, yet it misleads many people, including professionals, who jump to conclusions based on what has recently grabbed their attention.
Moreover, developing a set of technical rules when selecting “candidates” for the portfolio is enormously beneficial. Keep in mind that even if something works this year, it may not work next year. It is important that it works “on average”. One could employ accounting ratios such as return on equity/capital or trend-following indicators such as the simple moving average.
For instance, Joel Greenblatt outlines a very simple formula that beats S&P500 96% of the time, which is described in more detail in his book “The Little Book that Beats the Market”. In short, invest in companies with high return on capital and high earnings yield.
Better Investment Decisions
The psychology literature clearly states that people are not necessarily rational all the time. What about the “Efficient Market Hypothesis” and that prices reflect all available information? A combination of behavioural finance and a good understanding of financial markets can create powerful investment concepts.
Therefore, understanding under what environment investors are more prone to making mistakes is crucial to successful investing.