All people (even smart ones) are affected by psychological biases. However, traditional finance has considered this irrelevant. Traditional finance assumes that people are rational and tells us how people should behave in order to maximize their wealth. These ideas have brought us arbitrage theory, portfolio theory, asset pricing theory, and option pricing theory.
Alternatively, behavioral finance studies how people actually behave in a financial setting. Specifically, it is the study of how psychology affects financial decisions, corporations, and the financial markets. This book focuses on a subset of these issues-how psychological biases affect investors.
The Investment Environment
This information is very timely because the current investment environment magnifies our psychological biases. Several powerful forces have affected investors recently. First, a strong and extended economy has created the disposable income for millions of new investors to enter the investment world. Most of these new investors have little or no formal education in finance, which nowadays is one of the most needed industries when it comes to job searching. Second, this economy has spurred one of the longest and strongest bull markets in history. These new investors could have mistakenly attributed their high investment returns to their own capabilities instead of being a consequence of investing during a bull market. Finally, the rise of the Internet has led to increased investor participation in the investment process, allowing investors to trade, research, and chat online. These three factors have helped our psychological biases to flourish.
These ideas are well demonstrated by the cartoon in Figure 1.3 in which a roller coaster represents the modern investment environment. This roller coaster, like our stock market, has dramatic highs and lows. We go from a high to a low and back again these days at what seems like frightening speeds. Remember how you felt after your first roller coaster ride? The roller coaster causes strong emotions. Some people feel terrified while others are exuberant. Some people never ride another roller coaster, while others become addicted and wish to ride over and over again. Our new investment environment can also elicit emotions and enhance our natural psychological biases. These attributes usually lead to bad decisions. The rest of this book demonstrates these problems.
1. This exercise is similar to that of Hersh Shefrin, 2000, Beyond Greed and Fear, Boston, Massachusetts: Harvard Business School Press.
2. Roger Clarke and Meir Statman, 2000, "The DJIA Crossed 652,230" Journal of Portfolio Management, Winter: 89-93.
Not Thinking Cleaily
People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence.
Are you overconfident?
How many questions did you answer right in the previous chapter? If you selected a correct range nine or more times, then you may not be overconfident. However, I have asked these questions to many groups, and no one has answered nine or more correctly. Most people are overconfident about their abilities. Consider the following question.
How good a driver are you? Compared to the drivers you encounter on the road, are you above average, average, or below average?
How would you answer this question? If overconfidence were not involved, approximately one-third of those reading this book would answer above average, one-third would answer average, and one-third would answer below average. However, people are overconfident in their abilities. Most people feel that they are above average. When groups of students, professors, professionals, and investment club members were asked this question, nearly everyone answered that they are above average. Clearly, many of them are mistaken and are overconfident about their skill in driving.
Being overconfident in driving may not be a problem that affects your life. However, people are overconfident about their skill in many things. Sometimes overconfidence can affect your financial future.
Consider this financially oriented example. Starting a business is a very risky venture; in fact, most new businesses fail. When 2,994 new business owners were asked about their chance of success, they thought they had a 70% chance of success. But only 39% of these new owners thought that a business like theirs would be as likely to succeed.1 Why do new business owners think they have nearly twice the chance of success as others in the same business? They are overconfident.
We begin the process when we enter a new activity, say, investing. We do not know our ability at investing, so we observe the consequences Consider the Dartboard column frequently run by the Wall Street Journal Periodically, the Wall Street Journal invites four or five investment analysts to pick a stock for purchase. Simultaneously, they pick four or five other stocks by throwing darts at the financial pages. They follow the analysts' stocks and the dartboard stocks and report the returns produced by both sets. More likely than not, the dartboard portfolio beats the pros. Does the dart thrower have superior stock-picking ability? No, if s just that dumb luck success is common.
People investing during the late 1990s probably experienced great returns-it is easy to earn high returns during a strong, extended bull market. Many new investors began investing during this period. The problem arises when the newer investors attribute their success to their ability. Thus the old Wall Street adage warning "Don't confuse brains with a bull market!"
Psychologists have found that people become overconfident when they experience early success in a new activity. Also, having more information available and a higher degree of control leads to higher overconfidence. These factors are referred to as the illusion of knowledge and the illusion of control.
Illusion of Knowledge
People have the tendency to believe that the accuracy of their forecasts increases with more information. This is the illusion of knowledge-that more information increases your knowledge about something and improves your decisions. However, this is not always the case-increased levels of information do not necessarily lead to greater knowledge. There are three reasons for this. First, some information does not help us make predictions and can even mislead us. Second, many people may not have the training, experience, or skills to interpret the information. And, finally, people tend to interpret new information as confirmation of their prior beliefs.
To illustrate the first point, I roll a fair six-sided die. What number do you think will come up and how sure are you that you are right? Clearly, you can pick any number between 1 and 6 and have a one-sixth chance of being right. What if I told you that the last three rolls of the die have each produced the number 4? If I roll the die again, what number do you think will come up, and what chance do you have of being right?
If the die is truly fair, then you could still pick any number between 1 and 6 and have a one-sixth chance of being correct, regardless of what previous rolls have produced. The added information will not increase your ability to forecast the roll of the die. However, many people will believe that the number 4 has a greater (than one-sixth) chance to be rolled again. Others will believe that the number 4 has a lower chance to be rolled again. Both groups of people will think that their chance of being right is higher than reality. That is, the new information makes people more confident in their predictions, even though their chances for being correct do not change.
What return do you think the firm TechCron will earn next year? Don't know? Last year TechCron earned 38% and it earned 45% the year before that. Now what return would you guess?
Of course, TechCron is just a made-up firm, so you have no other information. But how is this example any different from rolling the die? Frankly, it is not different. Yet, investors commonly use past returns as one of the primary factors to predict the future. Have you switched your money into one of last year's best mutual funds?
Investors have access to vast quantities of information. This information includes historical data like past prices, returns, and corporate operational performance, as well as current information like real-time news, prices, and volume. Individual investors have access to information on the Internet that is nearly as good as the information available to professional investors. Because most individual investors lack the training and experience of professional investors they are less equipped to know how to interpret information. They may think they have access to all this incredible inside information and that may well be true, but, without the proper training, they cannot begin to guess how that information might shape the future- any more than they can guess future rolls of the die from what was rolled in the past.
The cartoon in Figure 2.1 illustrates this point. What is that guy saying? What does it mean? What should I do now that I have the information?
The last reason information does not lead to knowledge: People have a tendency to interpret new information as a confirmation of their prior beliefs. Instead of being objective, people look for the information that confirms their earlier decisions. Consider what happens after a company reports lower earnings than expected-the price usually falls quickly, followed by high volume. High volume means that many people decided to sell and others decided to buy.
Consider an earnings warning by Microsoft Corporation. Microsoft warned that earnings would be closer to a share instead of the expected. This warning was issued while the stock market was closed. What would you have done? As Figure 2.2 indicates, the opening trade for Microsoft was down $4.50 to $51 a share. When earnings information is released, prices quickly reflect the new consensus on the company. Note on Figure 2.2 that, after the initial price drop, the price hardly changed at all during the next hour of trading. If you think that Microsoft is not a very good investment, then the earnings warning probably induced you to sell. However, by the time you sold, you had already lost $4.50 a share. The only reason you would have sold after finding out about the price drop is if you thought that Microsoft would not be a good investment in the future. Or you might have felt that Microsoft is a good investment and used this warning as an opportunity to buy in at a low price. A lot of people were induced to trade on this news-nearly 1.9 million shares were traded in the first 5 minutes. Over half a million shares were traded every 5 minutes during the next 25 minutes of trading. Clearly, many investors wanted to sell and many others wanted to buy. One news report caused two different behaviors.