Behavioral Economics: Managing Your Inner Voice

Key theories in behavioral economics

The following paragraphs describe a few crucial biases and thought processes that we all harbor and that play a role in our investment decision-making. As you read them, consider how they may apply to you.

Bounded rationality: This concept, introduced by economist and Nobel Prize winner Herbert Simon, suggests that individuals have limited cognitive resources and cannot process all the information required to make perfectly rational decisions – put simply, we have limited bandwidth.

To overcome this failure, we often use shortcuts to make decisions that are "good enough." Simon called this adaptive process "satisficing." The term comes from the words "satisfy" and "suffice."

Prospect theory: Developed by Nobel Prize winners Daniel Kahneman and Amos Tversky, this theory describes how people evaluate potential losses and gains unequally. Many studies have found that most people are susceptible to loss aversion. In other words, we are more sensitive to losses than to profits. This bias leads to risk-averse behaviors when facing potential gains and risk-seeking behaviors when facing potential losses. In other words, we are more likely to double down on a losing position than a winning position.

Anchoring: This cognitive bias occurs when individuals rely too heavily on an initial piece of information (the "anchor") when making decisions. For example, many investors stay fixated on the price at which they bought an asset. In such a case, they may consider that to be the stock's fair value even if conditions change. Thus, if the stock falls, they may perceive it as undervalued regardless of why the price declined.

Overconfidence: Many professional and retail investors overestimate their knowledge and ability to predict market movements. This overconfidence can lead to excessive trading and risk-taking, often resulting in suboptimal investment outcomes.

Casinos and sports gambling sites prey on this bias. By default, the odds are less than 50% that a gambler will win a bet or hand. The more they play or bet, the better the odds they will lose money. So why do so many people bet and gamble? They have confidence that they have some knowledge or skill that others don't. This same behavioral trait holds for many investors.

Herd behavior: People often follow the actions of others, especially those deemed "experts" or that are viewed as popular. The social media term “influencer” applies to many in the financial media. The more uncertain the situation, the more this bias takes hold. Herd behavior, when strong enough, can lead to bubbles and crashes as investors push prices up or down based on the behavior of others.

If this weren't the case, stock valuations would remain stable. Sellers would emerge when valuations became rich, and buyers would step in when they became cheap. Today, valuations are at record levels despite growing concern about the market's fundamental economic underpinnings.

Let's focus on how those five concepts can impact financial markets.

How behavioral economics affects financial markets

Behavioral economics has underappreciated implications for financial markets. By understanding the psychological factors that influence investor behavior, we can better explain market anomalies and develop strategies to mitigate their impact on our returns.

Bubbles and crashes: Traditional economic theories don't explain why asset bubbles form and why they ultimately burst. If every investor were rational and fully aware of all available information, who would overpay for stocks, thus causing bubbles? Similarly, why do investors sell instead of buy once stocks become cheap?

Herding and overconfidence can be a winning combination in upward-trending markets. However, these behaviors often come at a steep cost. The combination of a belief that one can generate above historical returns over long periods and similar sentiment from the masses can move markets and individual asset prices well above rational valuations.

The process can be circular. As investors become enamored with their gains, confidence grows. In the process, they become less rational. Conversely, when stocks are cheap after a crash, many investors may have lost their confidence but cannot take advantage due to their loss aversion. In fact, many investors panic and sell when prices are at cheap valuations.

Over/underreaction to news: Sometimes, markets overreact to new information, causing prices to adjust quickly and often more than is warranted by the news. In such circumstances, prices will frequently reverse some of the overreaction and adjust accordingly.

Some investors have a three-day rule to avoid overreacting. They wait to see the market or asset price action for three days before acting. However, in strong trends, the rule can be harmful. Consistent overreaction to certain news and underreaction to other news, alongside herding, can extend prices well above what should be expected. In these cases, adjustments will occur but can take longer than many expect.

Other times, markets underreact to new information. Bounded rationality helps explain this phenomenon. At times, investors do not fully process, understand, or appreciate the implications of new information immediately. As a result, prices may gradually adjust as more investors become aware of the news and its impact.

Behavioral trading and portfolio management tips

With some behavioral biases in mind, it is worth sharing a few tips to help avoid being too reactionary or complacent during periods of high volatility.

Avoid overtrading: No one is smarter than Mr. Market, goes a Wall Street adage. Overconfidence can lead to trading more frequently than is optimal. Accordingly, the more trades you conduct, the higher the likelihood that Mr. Market will get the best of you.

Warren Buffett takes the logic to an extreme, asserting, "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

We believe overtrading can harm returns, and a strict passive buy-and-hold approach has drawbacks. Active portfolio management is essential as economic and market conditions change. The tricky part is learning when a trade makes sense and is logical versus when our biases get the best of us and force a trade.

Home/familiarity bias: Investors tend to favor domestic over foreign investments, a phenomenon known as home bias. They also prefer certain stock factors over others. For instance, the chase has recently been on for mega-cap stocks. As a result, some very cheap and poorly performing small-cap stocks are ripe for investment.

Succumbing to these biases can leave a portfolio inadequately diversified, thus offering more risk. Reducing or avoiding our home and familiarity biases open the door to more extensive potential investments. Think outside of your comfort box.

Disposition effect: The disposition effect refers to the tendency of investors to sell winning investments too early and hold on to losing investments for too long. This behavior is driven by loss aversion and the desire to avoid realizing losses. As a result, investors may miss out on potential gains and incur more considerable losses. Further, investors may miss out on better opportunities as their money and mind are tied up.

Behavioral portfolio theory: This theory, developed by Hersh Shefrin and Meir Statman, suggests that investors often create portfolios that reflect their psychological preferences and biases. By understanding these preferences, investors can better appreciate their blind spots.

The theory makes a case for investment advisors. Hiring someone to manage your money helps avoid a portfolio regulated by your biases. This is not to say that professionals don't harbor similar biases, but some are more adept at understanding their biases and working around them. Furthermore, while they have biases, they differ from yours and weirdly create diversification from the rest of your assets.

Summary

Behavioral economics provides valuable insights into the psychological factors influencing investment decision-making. Taming these flaws, or at least better appreciating them, should give us more comfort. Further, it will allow us to walk the fine line of active investing, where we are neither overly active nor excessively passive.

By acknowledging that we are not always rational and are subject to cognitive biases, we can better understand market anomalies and develop strategies to mitigate – and even take advantage of – their impact.

Michael Lebowitz is a portfolio manager with RIA Avisors and author for Real Investment Advice. For more information, contact him at [email protected] or 301.466.1204.

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