Investment and Human Psychology
Ever heard of ‘Jesse Livermore’? Well, you would have known him as one of the most successful traders who made it to the top 10 of the richest men in the world in 1929. Five years later, he was nothing but broke. How did that happen? He made his fortune with a gain of $100 million or 1.39 billion in today’s dollars by going short on the stock market during the crash of 1929. But he did not stop there. The lion had already tasted the blood and he wanted more. Later he went long on the market which slipped to its lows by mid-1932 and lost 40% of all his gains that he had made in 1929. The market recovered a little by 1933 from its lows when Jesse added on to his positions with more leverage. That was when he took the final blow when the market crashed again to the lows of 1932. He not only lost all his money but was also indebted to the tune of $5 million or 70 million in today’s dollars. Despite knowing the risk, he could not stop over leveraging himself and losing all he had in the end. Sadly, he took his own life in 1940.
There are many names like Jesse who made it big and later lost it all but there are also people who learnt from their mistakes and became successful in this investing world. Who could be a better example than ‘Ray Dalio’, the founder of Bridgewater Associates, the largest hedge fund in the world (AUM of $138 bn)? In 1982, Ray went short on the market with his view that the global economy was headed toward a depression. That was it. His prediction proved fatal for his fund as the market began a bull run with the U.S. economy enjoying the greatest non-inflationary growth in the history over the next 18 years. He went broke eight years after he started his hedge fund in 1975 in his two-bedroom apartment in New York City. Apparently, his overconfidence cost him everything he had built but he learned from his failure to create what is known to have generated alpha for his investors over the years. He writes in his book entitled “Principles: Life and Work,” — “In retrospect, my crash [failure] was one of the best things that ever happened to me because it gave me the humility I needed to balance my aggressiveness. I learned a great fear of being wrong that shifted my mind-set from thinking ‘I’m right’ to asking myself ‘How do I know I’m right?”
Jesse Livermore and Ray Dalio are the ones who generally have much more information than a retail investor has. Then, why did they fail? What made them take irrational decisions whether to overleverage the positions despite knowing the pitfall or to create unhedged positions on the market based on speculation? Well, nobody can beat the market (not me, that’s what efficient market hypothesis says). Okay, you may ask now what this efficient market hypothesis (EMH) is. The hypothesis says that a stock always trades at its fair value reflecting all the information that can determine the current share price. It means that no one can generate alpha (higher than market returns) consistently and one can generate higher returns only by making speculative investments that pose substantially higher risk as well.
But EMH assumes that the investors take rational decisions. But are they always rational? Did Jesse and Ray take rational decisions? Well, they themselves realised later that they had not acted rationally and exhibited psychological biases while making their bets on the market. Another field of study, known as ‘Behavioural Finance ’, says that investors often act under bounded rationality while managing their money and that means we are often not able to optimize how our money is invested. It also says that the inherent behavioural biases influence our decision-making process. Okay, but how?
Let’s take a look at some of the biases and understand how they lead to bad financial decisions.
Confirmation bias
Confirmation bias is the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it. It is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. For example, during the pandemic, investors who believed that the economy will not see a quick recovery soon, tried to collect data that substantiate their belief rather than looking at the investors’ sentiments. The best way to overcome this bias is to consider information from multiple sources.
Status quo bias
Status quo bias is an emotional bias in which a person tends to retain the current status, not willing to be exposed to change or any risk. It is reflected in conservative investors’ behaviour who prefer to maintain the status quo on their investment portfolio to avoid the risks associated with change in the investment strategy. Even during the current crisis when investors got a chance to buy stocks at all-time lows most of them did not enter the market and kept their portfolio unchanged to avoid more downside risk.
Overconfidence Bias
Overconfidence bias is an overestimation of our abilities, analytical skills. It is an erroneous belief of “I am better than others.” In a survey of 300 fund managers, conducted by James Montier, it was found that ~75% of fund managers rated themselves above average at investing and remaining rated themselves on the lines of average. Apart from finance, various surveys have suggested that it is the most pervasive bias of all, in one survey it has found that ~93% of drivers (in US) claim to be above average, similar finding were found for Lawyers, Doctors etc.
How does overconfidence bias affect us?
§ Illusion of Control — It is a tendency to overestimate our ability to control or influence the outcome of an event. Ellen Langer, a professor of Psychology at Harvard University explained it as — ‘confusion between skill and chance situations. It leads to increase in our confidence and risk appetite. It results in under-diversification of portfolio, increase in trading, overestimation of value of information.
§ Planning fallacy — Planning fallacy leads to overestimation of our rate of work hence underestimate the actual time required to do the work. It results in underestimation of risk.
§ Over Ranking — Past success may lead us to perceive ourselves as better than average, while the outcome could have been due to luck. This increases the risk-taking appetite of investor since risky investment now is perceived to be less risky.
A study on 10,000 retail investors has suggested that the more active the retail investor, the less money they make. It is because of overconfident bias that these retail investors were involved more in trading and didn’t try to diversify their portfolio. Overconfidence bias can be avoided by simply being aware of the fact that we exert this bias. Scepticism of future volatility, unpredictable market should be considered while making an investment decision. Past success should not influence the decision-making process and every decision should be treated as independent event.
Gambler’s Fallacy
Gambler’s fallacy is a person’s tendency to think that the future probabilities are altered by the previous events. Investors often take the contra call where if the market has seen an up move in the last few trading sessions, they tend to go short and if the market has seen a correction, they tend to make long positions. Here, the person tries to make a pattern where actually exists none and that makes them take erroneous decisions.
Bandwagon effect
It is a psychological phenomenon in which persons, regardless of their own beliefs, choose to do something solely because most of the other people are doing it. Trading psychology is affected too by the effect of the bandwagon. When an investor gets to know that there are many investors who hold the same position as he/she does, he/she feels more secure. Many investors like to follow the crowd, not performing their own analysis as it saves their time and cost of gathering information. Sometimes, it helps them make gains in the short run riding on the investors’ sentiments but when they lose, they lose big.
Hindsight Bias
Hindsight bias is a misconception of having accurately predicted an event after the happening of the event. It is also known as knew-it-all-along phenomenon. After the financial crisis many experts have claimed to have predicted the crisis all along, elaborating via various indicators. Hindsight bias has its roots in psychology, after an event has occurred, human brain tends to recognize pattern which make the outcome of event seems obvious. There are three levels of hindsight bias:
§ Memory Distortion — We all must have heard someone saying, ‘See, I told you so’. Many a times after the event has occurred, we claim that we knew it all along, research has suggested that we tend to be selective in recalling our memory of pre-event claim and remember the information which supports the claim.
§ Inevitability — It centres on our belief that it was meant to happen. We tend to create a pattern on effects and select the information in such a way the cause seems obvious/inevitable.
§ Foreseeability — It is an individual misconception where we personally feel that we had predicted the event, or we can predict outcomes of events.
Hindsight bias affects the complex decision-making process, by making one feel that solution was rather simpler and easily predictable one. Hindsight bias can be avoided by accepting the fact that we cannot predict future. While making investing decision one should create multiple scenarios in order to capture multiple outcomes. Make your decision objectively rather than intuitively. Lastly, always analyse the outcomes, and refine the factors where assumptions were taken.
Risk Averse
Risk aversion is a human behaviour in which they agree to a situation with a predictable pay off rather than unpredictable risky choice. A risk averse investor may prefer lower returns with known risks over higher returns with unknown risks. Risk averse generally prefer investments in bank deposit, public provident fund, short term debt funds etc. over the risky assets such as equity or commodities and even if they do invest in risky assets, they prefer to invest in assets which exhibits lower volatility.
Loss Aversion: Loss aversion is an individual tendency of people to prefer avoiding losses to acquiring equivalent gains. In other words, pain of loosing 10$ is far more than pleasure of gaining 10$. It is a common phenomenon among us all, and there can be many factors which affect loss aversion such as; neurological, socioeconomic and cultural. Dr. Daniel Putler in 1992, conducted a research where it has been observed that demand of eggs decreases by 7.8% when prices were increased by 10%. Whereas when prices were decreased by 10% demand only increased by 3.3% reflecting that individuals were affected by potential losses more than potential savings.
Loss aversion make investors behave irrationally and against their own interest. Hence it is imperative to assimilate that we exert this bias and be consciously make our investment decisions. It can be avoided by rationalizing our investment decision, focusing on goals, calculating one’s risk appetite and making investment strategy accordingly.
Thousands of people turn to the market every day with a view that they can make quick money from it and most of them start as day-traders who use leverage made available by the stockbrokers to take big shots in order to enhance their gain without understanding the risk of losing it all. To explain in simpler terms, suppose a newbie comes to the market with a sum of Rs. 1 lakh. Now, his stockbroker gives him an option to trade with 5–30 times of the money that he brought with himself. Yeah, you heard it right. He can trade in a volume of Rs. 5 lacs to 30 lacs (depending on the leverage being provided by the broker). Let’s say he exercises 10x leverage to buy stocks worth Rs. 10 lacs. Now, if the stocks rise 3% from the level that he bought on, he earns Rs. 30K. Wow, 30% return in one shot, isn’t that amazing? That’s how most of the traders feel initially, thinking of it as easy money. Now, what happens if things go south, what happens when the stocks drop by 3%? Yes, you can do the numbers. Sadly, most of the new traders are positively biased who play by their guts and fail to understand the downside risk. Even if we set aside the leverage part, people lose money as their biases make them take irrational decisions. So, a million-dollar question is how can we overcome these biases. Sadly, we can’t get rid of them as these are inherent in us. Most of the people learn the hard way when they suffer huge losses which makes them understand that they can’t make money with speculation. Most of the investors who put money in direct equity instead of Mutual Funds once start as a trader and turned out to be an investor after getting setbacks. If one doesn’t want to take a full circle, one should start by educating himself/herself of the fundamentals, understanding the risk and setting a maximum limit on what they can afford to lose so that he/she can pull the plug when things go south. More than skills, it takes a lot of discipline for making money in the market. So, the next time when you’re putting your money somewhere, make sure you don’t do it just because you feel like doing it.
References:
1. “From $1.4 Billion to Bankrupt in 5 Years — Lessons of a Speculator”, Stefan Orlik, September,2017
https://blog.topsteptrader.com/lessons-from-jesse-livermore
2. “World’s Top 10 Hedge Fund Firms”, Andrew Bloomenthal, March 2020
https://www.investopedia.com/articles/personal-finance/011515/worlds-top-10-hedge-fund-firms.asp
3. “Ray Dalio went broke and nearly shut Bridgewater before turning it into biggest hedge fund ever”, Tae Kim, September 2017
https://www.cnbc.com/2017/09/15/ray-dalio-went-broke-and-nearly-shut-bridgewater-hedge-fund.html
4. Behaving Badly — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563
5. https://en.wikipedia.org/wiki/Illusion_of_control
6. https://www.investopedia.com/articles/investing/050813/4-behavioral-biases-and-how-avoid-them.asp
7. https://thedecisionlab.com/biases/loss-aversion/
8. https://www.bloombergquint.com/opinion/how-loss-aversion-affects-your-investments
By Avinash Anand
Class of ’21 | Indian Institute Of Management Tiruchirappalli
Shantanu Pandey
Class of ’21 | Indian Institute Of Management Tiruchirappalli
