Business Development

131 | Why your brain makes bad investing decisions

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Tutor:

  • Stuart Rae, CIO - Asia Pacific Value Equities, AllianceBernstein

Learning outcomes:

  1. How emotions can influence investment decisions
  2. The major behavioural biases that affect decision-making
  3. How rules-based investing can help to overcome biases

Channel

Business Development
Stuart Rae: Human behaviour is anything but rational. The boundary between rational and irrational behaviour is very blurry. Every day, our decisions are influenced by forces at work deep inside our brains. Understanding how these biases affect financial markets can help improve your decision making—and even your investment returns. Voiceover: Your brain is a hugely complex organ that developed over millions of years. It helps to think about it as actually three different brains. Deep down in the core is your original “lizard brain” which keeps your basic functions ticking over and handles some very basic instincts like “fight or flight”. Wrapped around that is your “mammal brain”, which handles things like emotions, memories and habits. It helps steer decision making based on what makes you happy but it can also mislead you. At the highest level of brain function is the neocortex; this makes you human. It handles abstract thought, reasoning, self-reflection and consciousness. Within your mammal brain are two small regions, one on each side, called the amygdala, which process emotions and memories and drive reactions and decisions. Signals from the amygdala are so powerful that at times they can overwhelm your neocortex and hijack your normal rational behaviour, like when you have that one more piece of cake or that one more drink when you really shouldn’t. Stuart Rae: This primitive brain isn’t all bad. It helps us find pleasure, avoid pain, have confidence, and protect people and things around us. But it just tends to get carried away sometimes. And it often obstructs rational decision making in complex situations. Voiceover: Here’s a classic example. Imagine you have two doors to choose from. Door A offers an 80% chance of winning $4,000. Open door B, and you are guaranteed $3,000. Which is most appealing? Door A is the rational choice. Its expected value is 0.8 times 4,000 or $3,200—more than the guaranteed $3,000 from door B. But studies show that four out of five people choose the guaranteed, lower amount. Why gamble when you can take the sure thing? Now let’s reverse the dilemma. Door A gives you an 80% chance of losing $4,000, while door B gives you a 100% chance of losing $3,000. In this case, most people will gamble to avoid the certain but smaller, loss of $3,000. It’s the same problem. So why do people prefer to take the certain gain, but gamble to avoid the loss? Stuart Rae: The answer lies in your emotional response to gains and losses. The additional pleasure you get from more and more gain lessens with each incremental step. But the pain curve is much steeper. Losing hurts, so you’ll gamble to avoid that pain. That’s why human decisions in the two cases are so different. Still think you’re a rational decision maker? Here’s another classic experiment by two psychologists, Amos Tversky and Daniel Kahneman, to see how easily your decisions can be manipulated. Voiceover: They set up a big wheel that was rigged to land on one of two numbers, either 10 or 60. Participants in the experiment spun the wheel, watched where it landed, and then had to answer an unrelated question about what percentage of UN countries are African. The results show that people get “dragged” in the direction of the number they just saw. Those who spun a 10 on the wheel guessed on average 25% of UN countries were African; while those who spun a 60 guessed a much higher 45% were African. Stuart Rae: Those are two common biases – the asymmetry of gains and losses, and “leading the witness”. There’s a whole bookshelf full of these. Overconfidence: people tend to think they’re better than average in many areas. Gambling is about how people systematically over-estimate their chances of winning a very large payoff. The endowment effect is about how owning something endows it with a higher value and explains why people are often reluctant to throw away old and useless things. And the human brain also sees patterns in everything, even when they don’t exist. Investors are ultimately, human, so they’re prone to all of these biases. Take loss aversion. Investors who see their results more frequently are easily manipulated to feel more pain. Think about 2016. Global stocks rose by 7.5%. Investors felt good. But on a monthly basis? Very different picture. The annual result is exactly the same, but now you see negative returns in four out of 12 months. That feels much riskier – especially the big loss in January. In one experiment in the US, two groups of potential investors were shown the same set of equity market return data. But one was monthly, and the other annual. Monthly returns are more volatile and show more negative numbers. Then they were asked how much they wanted to allocate to equities. People seeing the monthly data chose a dramatically lower equity percentage, just 41%. Those who saw the annual data said 70%. The psychologists then altered the data. All the returns equally were moved up to eliminate any negative data. Same volatility, but all the returns were now positive. This time, both groups of investors made exactly the same decision on equity allocation. So it was loss aversion driving their non-rational decisions. The moral of this story? Don’t look at your returns too often! Voiceover: The next bias is over-confidence. This study looked at investment returns for 78,000 US households based on how often they traded. Households with the lowest turnover enjoyed annualized returns of 18.5% -7 percentage points higher than households with that traded most frequently. Overconfidence typically leads to more trading, which leads to worse returns. Gender also matters. This study shows that on average, single men lost about 3% a year versus just holding onto their starting portfolio. Single women also lost, but much less, only 1.5% a year. The main difference was less trading. What about married women? A little worse than single women, because they traded more. We can speculate about why that might be. Stuart Rae: These biases are linked to investment styles. Value investing takes advantage of loss aversion, growth investing is helped by sell-side anchoring and low-volatility investing plays against the gambling effect. Value investing is about finding companies whose share prices have fallen too sharply. When a company is in trouble, loss aversion prompts investors to sell stocks more than is justified because they hate losing. And anchoring makes it hard for investors to see signs of a turnaround. Eventually, when a company recovers, its stock will revert to the mean. This explains why cheap stocks statistically tend to outperform over the long term. For growth investors, the challenge is to avoid following hot trends by buying companies with strong historical earnings, sales or asset growth. Instead, they need to find companies that can deliver consistent future growth. More subtle measures of success such as free cash flow profitability or incremental cash flow on assets, tend to be more persistent. While many investors are influenced by the anchoring bias, which ties perceptions to the past, a skilled growth investor can apply good insight into a company’s future outlook and “get ahead of the market”. Low-volatility investing takes advantage of investors’ gambling tendency. Portfolio managers are easily incentivised to take big risks to deliver blockbuster results. This gambling tendency means that high-beta stocks – which move more than the market on the upside and downside—are systematically overbought. You might think that low-beta stocks would do worse over time, since they tend to lag in a rising market. But in fact, low-beta stocks outperform over the long run because they lose less in a downturn, which allows them to recover faster when markets rebound. Many active management strategies are based on human behavioural biases. But you need a process that “protects” the portfolio managers against the biases they are trying to exploit. When done correctly, disciplined and insightful managers can beat the market. So now that you understand human behavioural biases, how can you become a better decision maker? Start by slowing down your brain. Sometimes intuition is right. Often it’s not. Voiceover: Remember the three brains? Don’t let your mammal brain hijack your higher-order thinking. Turn it off and switch on your human brain. Slow down your thinking process and your decisions will get more rational. And think about problems in different ways. Stuart Rae: The classic balance here is between what’s termed “the outside view” and “the inside view”. The outside view is about averages and statistics. How likely is this outcome based on what’s happened before, in similar cases. The inside view is about the specifics of a particular case. Focusing only on an “inside view” may anchor you to information that reinforces your view. The trick is to challenge yourself by using many sources of information—and start with the outside view first. In the investment world, one way of thinking about outside and inside views is quantitative and fundamental research. Quant works on averages and on correlations and it’s applied best to broad sets of data. Fundamental research homes in on the specifics of one company. At AllianceBernstein, we synthesize quantitative and fundamental research in our equity investment portfolios. The combination can be more powerful than either approach alone. And we think it’s the best way to ensure that we overcome the biases that make us human in order to capture the strongest long-term return potential for our clients.