You’re only hu­man: How it hurts your in­vest­ments

The Washington Post Sunday - - BUSINESS - Barry Ritholtz

I re­cently had the priv­i­lege of sit­ting down for a chat with Richard Thaler, pro­fes­sor of the Booth School of Busi­ness at the Univer­sity of Chicago. Thaler is widely rec­og­nized as the fa­ther of be­hav­ioral eco­nom­ics. He is peren­ni­ally on the short list for a No­bel Prize in eco­nom­ics.

His ob­ser­va­tions about how peo­ple be­have in the real world are a welcome change from the ba­sic as­sump­tions of most econ­o­mists. Thaler breaks down the world into two sorts of peo­ple: Econs, the ar­ti­fi­cial con­structs of how peo­ple are sup­posed to be­have. They are per­fectly ra­tio­nal, have great self­con­trol, cal­cu­late like ma­chines and know ex­actly what is best for them­selves.

Then there are Hu­mans, who do all of the things that tra­di­tional eco­nomic the­ory sug­gests they should not. They re­act emo­tion­ally, lack pa­tience, fail to con­sider con­se­quences and seem to be flum­moxed by math­e­mat­ics. They are filled with all man­ner of bi­ases and judg­ment er­rors. How the Hu­mans get through each day must ap­pear to be a mi­nor mir­a­cle to the Econs.

Thaler tells the story of how be­hav­ioral eco­nom­ics de­vel­oped in his new book, “Mis­be­hav­ing.” Thaler’s great in­sight— that peo­ple do not be­have like Econs — is what the ti­tle is ref­er­enc­ing. This has all sorts of fas­ci­nat­ing im­pli­ca­tions, per­haps none greater than how ir­ra­tional hu­man be­hav­ior is when it comes to in­vest­ing.

Let’s look at how these be­hav­iors man­i­fest them­selves for in­vestors— and what you can do about them.

En­dow­ment ef­fect: In one of Thaler’s early ex­per­i­ments, peo­ple were given mugs with a school’s logo— es­sen­tially worth­less baubles. Peo­ple turned out to be will­ing to pay far less to buy them than they were will­ing to sell them for. In other words, they at­tached a higher value to an as­set they al­ready owned than ones they didn’t.

The im­pact of this is sig­nif­i­cant for port­fo­lio man­age­ment. In­vestors tend to think more highly of the hold­ings that are sit­ting in their ac­counts than the rest of the in­vestable uni­verse. This is true for stocks, mu­tual funds, alt in­vest­ments and ex­change-traded funds (ETFs).

Per­haps this ex­plains why so many peo­ple have a hard time “cut­ting their losers.” They be­lieve their own hold­ings are more valu­able than what the mar­ket is telling them.

Sunk cost fal­lacy: Imag­ine you are in a res­tau­rant, and you or­der an ex­pen­sive dessert. You do not es­pe­cially like it, de­spite (or per­haps be­cause of ) the 1,000 calo­ries it con­tains. You eat it any­way— af­ter all, you al­ready paid for it!

This is a per­fect ex­am­ple of the sunk cost fal­lacy. Thaler sug­gests what you should be think­ing is: “Since I have al­ready paid for this, why should I suf­fer the caloric con­se­quences of eat­ing some­thing I don’t like? It’s paid for whether I eat it or not!”

Now think about a stock or fund you own (en­dow­ment ef­fect in­cluded). You have paid for it, but more than that, you in­vested time and energy into it: You re­searched the com­pany, you know who the se­nior man­age­ment is; you have kept up with all the news about the firm, its latest prod­ucts, quar­terly earn­ings, con­fer­ence calls, etc.

You have sub­stan­tial sunk costs, even if it the com­pany turns out to be a dog. The proper re­sponse is that those costs are al­ready gone, never to be re­cov­ered. Hence, you should not stay mar­ried to a hold­ing sim­ply be­cause of those al­ready in­curred ex­penses. The same is true for any hold­ing, be it a hedge fund, pri­vate eq­uity or ETF.

Loss aver­sion: Per­haps the most im­por­tant in­sight Thaler dis­cusses is our ten­dency to­ward loss aver­sion. As it turns out, peo­ple feel the pain of loss about twice as much as they de­rive plea­sure from gains. There are lots of pos­si­ble rea­sons for this, but per­haps the sim­plest is that gains seem tem­po­rary— even­tu­ally, they are spent or oth­er­wise fade into the back­ground. Losses, on the other hand, are per­ma­nent.

Loss aver­sion is why in­vestors be­come timid af­ter stock mar­ket crashes. Look at any port­fo­lio— your own in­cluded— since the great re­ces­sion and mar­ket crash of 2007-2009. You prob­a­bly have less eq­uity than you should. As­sets per­ceived as less risky are prob­a­bly over-weighted. This will re­duce the volatil­ity of your in­vest­ments— but it will re­duce their per­for­mance as well.

Hind­sight bias: You saw the 2008 col­lapse com­ing, right? It was so ob­vi­ous, you could not miss it. Hous­ing peaked in 2006 — you saw that, too. And the dot­com col­lapse— weren’t you warn­ing your friends about the ridicu­lous val­u­a­tions?

Sure you were! A tiny num­ber of peo­ple were warn­ing about those things— and they were mostly ig­nored as cranks. But in your own mem­ory, know­ing what you know now, of course, you were cau­tious then! That cog­ni­tive er­ror is at­trib­ut­able to hind­sight bias. You re­call— quite in­cor­rectly— be­ing on the right side of those col­lapses when (sta­tis­ti­cally speak­ing) you most cer­tainly were not.

One ofmy fa­vorite speeches to make at con­fer­ences is called “This is your brain on stocks.” To demon­strate hind­sight bias, I ask “How many of you knew the mar­ket was go­ing to col­lapse in (fill in the crash)?” About half the hands go up. “Think back to the trades you made then. How many of you shorted Lu­cent or Cisco or Ya­hoo or SunMi­cro in 2000?” Al­most all of the hands go down. “Did you sell the home builders short in 2005 or the banks in 2006?” No hands are still raised.

If you were so con­fi­dent that you saw it com­ing, why did you fail to profit from it? The an­swer is— de­spite what your brain is telling you to­day— that you never saw it com­ing.

Do­ers vs. plan­ners: Ev­ery­body wres­tles with con­flict­ing im­pulses. Your de­sire to en­joy things now runs head­long into your un­der­stand­ing that you must an­tic­i­pate fu­ture needs. Thaler named these im­pulses the Doer and the Plan­ner.

The ram­i­fi­ca­tions of giv­ing in to the Doer are many. We are couch pota­toes watch­ing TV in­stead of do­ing the ex­er­cise we know is good for us. We or­der the ba­con cheese­burger in­stead of the salad. When it comes to sav­ing for re­tire­ment, the Doer spends much more of his in­come than the Plan­ner would like.

The key take­away from Thaler’s re­search is as ob­vi­ous as it is dis­turb­ing. We can­not trust our­selves to think clearly, to plan pa­tiently or to make the right de­ci­sions on a con­sis­tent ba­sis.

Rather than as­sum­ing your brain knows what’s best for you, you need to make bet­ter de­ci­sions in­su­lated from cog­ni­tive foibles. That three­p­ound brain has 200 bil­lion neu­rons and 125 tril­lion synapses and is a marvel of biome­chan­i­cal en­gi­neer­ing. It evolved to keep you alive on the sa­van­nah. It’s less suc­cess­ful at sur­viv­ing riskre­ward de­ci­sions in the cap­i­tal mar­kets.

Hence, why I ad­vise you to not let your wet­ware in­ter­fere with your in­vest­ment process. Out­smart your brain. Own a broad as­set al­lo­ca­tion of diver­si­fied low-cost ETFs, re­bal­ance regularly— and stay out of your own way.

Per­haps the most im­por­tant in­sight Thaler dis­cusses is our ten­dency to­ward loss aver­sion.

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