Old Upset

"We're Only Human" – A Look Inside the Psychology of Investor Behavior

Old Upset

"The investor's chief problem, and even his worst enemy, is likely to be himself."

- Benjamin Graham, The Intelligent Investor; A Book of Practical Counsel, 1949

How these words ring true, even six decades later. Today, most of us can admit that we do not have a great track record of making good decisions when it comes to investing. Buying high and selling low and repeating until broke1 is a common practice a lot of us follow – not because we are continually trying to hurt ourselves, but because we really cannot help it.

Jason Zweig, columnist for The Wall Street Journal, offers his opinion on how humans are not hardwired to be good investors. In his book Your Money & Your Brain2, Mr. Zweig dissects the human brain to discuss how humans are motivated to make decisions - mainly out of fear and greed. He explains why these emotions are valuable attributes for survival, but a naturally horrible genetic makeup for dealing with our money. Specifically, he states, "for most purposes of our daily life, your brain is a superbly functioning machine, instantly steering you away from danger while reliably guiding you toward basic rewards like food, shelter, and love. But that same intuitively brilliant machine can lead you astray when you face the far more challenging choices that the financial markets throw at you every day." Emotions such as fear or greed often trump our logic, especially when fueled by certain behavioral biases, and leading us all to the same conclusion – we are really not as smart as we think we are.

The empirical evidence seems to support this conclusion.

Every year, DALBAR releases their Quantitative Analysis of Investor Behavior (QAIB)3 study, measuring the impact of investor behavior on investment returns. As the first half of the chart below indicates, the return received by the average equity investor severely lagged both the S&P 500 and IFA's Index Portfolio 100. The second half of the chart reveals the startling differences in accumulated wealth based on a starting investment of $100,000. DALBAR reports that psychological factors account for the bulk of this shortfall.

What causes us to have such poor judgment? Some of the more prominent behavioral biases include: regret avoidance, attribution bias, confirmation errors, anchoring and extrapolation, familiarity bias, irrational escalation, and framing. For more information on these biases and how we can attempt to control them, IFA recently produced two segments on IFA.tv that further delve into investor psychology and the impact it has on our investing experience. Scott Bosworth from Dimensional Fund Advisors (DFA) discusses these topics in detail and the implications for investors as seen through the lens of two competing theories of capital markets – the Efficient Market Hypothesis and Behavioral Finance.

Interestingly enough, these behaviors are not specific to non-professionals.

Nobel Laureate Daniel Kahneman describes the investment industry as being no more immune from psychological biases than anyone else. He states, "a major industry appears to be built largely on an illusion of skill."4 In congruence with the Efficient Market Hypothesis, Professor Kahneman challenges the notion of any one person having more information than the entire market. "The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion."

The empirical evidence seems to support Professor Kahneman as well.

Active managers, on average, underperform their respective benchmarks overtime once costs are taken into account. IFA recently published an article comparing the year-end results of mutual funds to their appropriate index benchmarks utilizing the research from Standard & Poor's. In 2012, almost two-thirds of all U.S. equity funds underperformed their benchmark. What is more intriguing is for the 5-year period ending September 30, 2012, there was no significant persistence in outperformance among active mutual fund managers – less than what is expected by random chance. In other words, luck, not skill, was the driving force behind active management outperformance. And partnering with lady luck is no better than making blind guesses. Or as Professor Kahneman likes to put it, "what you would expect from a dice-rolling contest."

If professional money managers have a very difficult time outperforming the market beyond what is expected by random chance, then why do investors still partake?

"We're only human" doesn't seem like an adequate enough answer. Our guess is that most people are deciding to invest without having a professional to help guide, coach, and educate them on the complexity of the capital markets and how to harness them to achieve their unique financial goals.

IFA suggests that investors work with a fiduciary wealth advisor whose job it is to keep them committed to a long-term plan. By doing so, investors can better temper those emotions that stir anxiety through the ups and downs of the markets - which can be quite significant at times - and prevent what could be a potentially costly mistake.

Think of it as an insurance policy against ourselves!

1. Richards, Carl. The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money. New York, New York: Penguin Group, 2012.

2. Zweig, Jason. Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. New York, New York: Simon & Schuster, 2007.

3. DALBAR. "Quantitative Analysis of Investor Behavior." 2013

4. Kahneman, Daniel. Thinking, Fast and Slow. New York, New York: Farrar, Straus and Giroux, 2011.