Understanding behavioral finance

The field of behavioral finance has exploded over the past few years, making it a go-to topic for education providers. While the human brain may be endowed with an amazing capacity for abstract, rational thought, it is often betrayed by our primitive emotions of fears and greed.

So how does one become a star investor?

“It’s not about spreadsheets,” said Michael Mauboussin, chief investment strategist, Legg Mason, speaking at the recent Morningstar Investment Conference. “Rather, it’s all about temperament; the ability to make good decisions under all conditions – especially fear and greed. Most of us, however, are not good at this.”

Investors are plagued by various innate human tendencies, including a proclivity for taking an inside view rather than and outside view. The inside view sees each decision as a unique situation and the decision maker approaches it as such.

This tendency narrows the investor’s focus to just the information that is immediately relevant to the security they are considering. They may focus on proximate drivers of performance, rather than the ultimate drivers. Taking the outside view, the investor places the decision in the broader historical context, giving them more of a macro-view of ultimate drivers of performance.

“Ask the question: what’s happened to other people in this situation before? This is a very unnatural way to think, because you leave aside all the information that you’ve gathered, and you effectively have to default to the database of humanity,” he explained.

Human nature also prefers language over numbers, in that anecdotes can sway opinion against an option that may be sounder from a statistical viewpoint. Mauboussin cited a study in which subjects were asked to decide between two medical procedures, one with a 90% success rate and one with a 50% success rate.

The control group invariably chose the procedure that was successful 90% of the time. The experimental group was presented with the same options, but the researchers also revealed a negative anecdote about the more successful procedure, with no anecdote about the less successful procedure.

In this group, only 39% of subjects chose the procedure with the 90% success rate, despite the clearly better odds. The lesson for financial advisors is clear: if there is a preferred choice for the client, you should illustrate that choice with a positive anecdote.

Skill vs. Luck

One crucial problem investors face is the challenge of distinguishing skill from luck.

In any enterprise that combines skill with luck – such as stock picking – there is tendency for results to revert to the mean. The greater the role of luck, the greater the tendency to mean reversion. In a purely skill based enterprise, the tendency is weaker.

Mauboussin gives the example of golfer Phil Mickelson, whose score will seldom revert to the mean of “par” for any given golf course. A golfer who relies more on luck will tend to revert to a higher mean score.

Few investors understand the nature of luck, Mauboussin said, as it allows for change and no-change to coexist.

In a purely luck-based market, the returns of a set of stocks might fall along the line of a traditional bell-curve. But it would defy logic to assume that each stock would repeatedly land in the same part of that curve.

Skillful investors recognize this and apply their understanding of corporate fundamentals to select the stocks which they expect to outperform the overall market.

The argument is repeatedly made that such skill is in fact an illusion, and that investors would be better off holding the entire market in a lower cost structure, such as an exchange traded fund. This argument, however, plays into another human weakness, the will to conformity.

In evolutionary terms, standing out from the crowd was often a good way to become a meal for a predator. While few saber-toothed cats have been spotted in the corridors of high finance, these locales are none-the-less teeming with predators. Unfortunately, our herding instinct works against us in this setting.

Conformity, Mauboussin explained, limits market efficiencies, whereas diversity increases efficiencies. Imagine for a moment that all investors used an ETF that tracked the S&P 500 for their U.S. large cap equity exposure. The market would be devoid of proper price discovery and assume that the prices assigned to the cap-weighted index were correct.

In a world with no direct shareholders, only ETF exposure, it is unclear how the underlying securities would be priced at all.

Conformity can threaten the returns of active investment strategies as well, however, and investment teams must guard against group-think. Mauboussin says his team assigns a probability to each outcome they foresee in a given security. They keep investment meeting short, as longer meetings may tend to create factions for and against an investment thesis.

For a contentious security, analysts are divided into teams to research the bull-thesis and the bear-thesis.