Human psychology and investment strategy could seem to make for strange bedfellows. But according to Richard Thaler, the Nobel Prize-winning economist, the two are inextricably intertwined.

Thaler is an academician and his investment theories are used by the $5.2 billion Undiscovered Managers Behavioral Value Fund. The Fund’s stock picks aren’t based solely on financial data. They also take into account the fact that investors are human, and they often behave irrationally.

Should the fact that humans often do things that aren’t based on logic influence an individual’s investment decisions?

The Undiscovered Managers Behavioral Value Fund proves that choosing stocks using this non-traditional approach can provide returns that are comparable to the index against which the fund is compared.

Here are the returns that the fund has made since its inception in December 1998.

Performance of the Undiscovered Managers Behavioral Value Fund Class L as on October 31, 2019

 YTD (Monthly)1 Yr3 Yrs5 Yrs10 YrsLife
Undiscovered Managers Behavioral Value Fund Class L
14.61%

0.39%
6.67%6.74%13.37%11.44%
Russell 2000 Value *15.55%
3.22%
8.6%6.24%11.08%
8.8%

* Russell 2000 Value is a small-cap stock market index

This article will examine the different aspects of human nature that can lead investors to make the wrong decisions. It will also look at ways to reduce the negative impact that these can have on an investor’s returns.

Why investors behave the way they do

Here are brief descriptions of several types of irrational investment behavior. Readers may notice that some of them are all too familiar.

1. Herd Mentality

Investors should buy low and sell high. Right?

But they often do the exact opposite.

Why should an investor buy a stock when its price is high and sell when the valuation falls? Acting in this manner defies all logic.

One of the reasons for this senseless conduct is that “herd behavior” is hard-wired into our brains. Investors think that if everybody is buying the same stock, they can’t all be wrong. FOMO (fear of missing out) and the desire to conform to what others are doing also play a large part in these irrational investment decisions.

The dotcom bubble of 2000 saw companies like Pets.com, a firm that specialized in selling pet supplies to retail customers, and Boo.com, an online bookseller, destroy large amounts of investor wealth.

In the five years leading up to 2000, the NASDAQ Composite, a stock market index that includes many tech stocks, quintupled in value. Plumbers, dentists, schoolteachers, and everybody in between had suddenly become stock-picking experts. It was hard to go wrong in the dotcom boom.

However, when the inevitable market crash came, the fall was swift. The NASDAQ lost 78% of its value between March 10, 2000, and October 9, 2000. Investors watched helplessly as their paper profits disappeared. Many sold their shares at a fraction of the price at which they had made their purchases.

2. All or nothing mentality

Investors are often tempted to put all their money into a single stock or one sector. It could be, say, Apple stock, or real estate, or a biotech company.

Even if these investments provide high returns, it could lead to losses in the long-term. Why? Because encouraged by their recent success, they are more likely to bet all their money on the next “sure thing” or “no-risk” investment. They are setting themselves up to lose. It’s highly unlikely that an individual would make a series of high-risk profit investments that result in a profit.

There’s another facet of human nature at play here. It’s the “house money effect.” Investors often don’t treat the profits they have made in the market in the same manner as their other money. Their stock market gains are treated as house money or winnings at a casino. These funds are often deployed in high-risk investments.

3. Loss-Aversion

Say, an individual buys a stock at $100. Its price subsequently falls to $90. Over the months, it drops further. A year goes by, and the valuation remains in the $50 to $70 range.

The investor realizes that he’s overpaid for the stock. But he still doesn’t sell. Why? He’s waiting for the price to rise to $100 again. Making a loss on the transaction is too painful.

Psychologists say that losses hurt about twice as much as similar-sized gains. Overcoming this instinctive behavior can help investors minimize their losses when they have made a poor investment decision.

4. Anchoring

Also known as “looking for bargains in the wrong place” – investors are often tempted to buy a stock when its price is falling. The decision to purchase the share is based on the premise that sooner or later, the price will rise and regain its original level.

This irrational line of reasoning is attributed to a behavioral bias called “anchoring.” An investor can erroneously “anchor” a stock’s value to its original price. However, the share’s value may have fallen because of a change in market conditions. A competitor may have designed a better product or gained access to a source of low-cost raw materials.

Let’s examine the idea of anchoring with an example.  

Today, Sears’ stock trades at $0.27. Just two years ago, the retailer’s shares were priced at  $4.57. Go back five years, and the stock was at $37.

An investor who “anchored” Sears’ price to its earlier valuation would have seen a buying opportunity at every stage of the fall. However, the decline in Sears’ price is because of the “Amazon effect.” Brick and mortar retailers have been unable to compete with Amazon’s e-commerce platform. There seems to be little hope for traditional retailers like Sears.

There’s another behavioral quirk at play here. Investors often suffer from an “optimism bias.” They think that the financial decisions they make will turn out well. They come to this conclusion even when there is no hard evidence to back their thinking.  

Research carried out by neuroscientist Dr. Tali Sharot at University College, London, found that 80% of people display “optimism bias.”

97% of day traders lose money

If there is one type of investment that illustrates how hope can triumph over reason in peoples’ minds, it’s day trading.

The online brokers who promote this speculative activity portray it as a simple way to make money. According to them, all an investor has to do is buy or sell a stock or other financial security and close the trade within the same day. Some trades will result in a profit while others will lead to a loss. The investor just needs to ensure that the overall result is positive.

The selling points of day trading could prove irresistible. The broker points out that it’s entirely possible for experienced investors to live off the gains made from day trading.

When an investor receives this information, it’s difficult not to visualize a life of leisure and riches. The optimism bias kicks in, and it’s hard to resist the urge to sign up and begin trading.

However, the reality can be quite different.

A study titled Day Trading for a Living? that observed individuals who started day trading between 2013 and 2015 in the Brazilian equity market found that:

  • 97% of the traders lost money.
  • Only 0.4% made more than $54 per day.
  • The most successful trader made $310 per day.

While it’s certainly not impossible to make a decent return with this form of investment, the vast majority of investors don’t break even.

Behavioral funds to the rescue?

There are a number of funds that try to focus on making investments in stocks that are mispriced because of the behavioral errors made by investors. The fund manager identifies shares that are undervalued because thousands of investors have based their investment decisions on irrational factors. The idea is that over a period, the stock’s value will correct itself, leading to a rise in the fund’s net asset value.

A study carried out by MutualFunds.com, a research company, lists 22 behavioral funds. However, the 2017 study doesn’t find the returns that these funds offer to be particularly attractive.

The Undiscovered Managers Behavioral Value Fund mentioned at the beginning of this article has provided reasonably high returns. It has even beaten the Russell 2000 Value, the small-cap index against which its performance is measured, in certain years.

But the Undiscovered Managers Behavioral Value Fund is one of the better performing funds in its category. Investors need to be careful before deploying their money in this category of funds.

Index funds could offer a better option

Behavioral investing hasn’t gained much traction. After all, identifying low-priced stocks based on the idiosyncrasies of other investors isn’t easy. There are innumerable factors that influence a stock’s valuation. How is it possible to single out the shares that are mispriced because of the irrational thinking of investors?

Index funds could be a better bet. Consider the performance of the S&P 500 over recent years:

Performance of the S&P 500 Index – annualized return

Last one year (as of October 31, 2019)14.3%
3 years14.9%
5 years10.8%
10 years13.7%

If an individual had invested in an index fund tracking the S&P 500 ten years ago, the returns would have exceeded 13% on an annualized basis.

The potential of index investing is best illustrated by the challenge legendary investor, Warren Buffett, threw to the hedge fund industry back in 2008. Buffett held the view that the hedge fund industry’s “two and twenty” fee arrangement was unjustified. Hedge fund managers traditionally charged investors a 2% management fee as well as an additional incentive fee of 20% of the profits that the fund made above a predefined level.

The fact that the fees were exorbitant wasn’t Buffett’s main issue. He said that the returns hedge funds provided were less than the rate investors could earn by deploying their funds in an index fund.

Buffett bet a million dollars on the S&P 500 beating the return that hedge funds could make. Asset management and advisory firm, Protégé Partners, took up the challenge and selected five hedge funds for the bet.

The final result? The S&P 500 gained 126% in the bet’s ten-year period from 2008 to 2018. What about the hedge funds selected by Protégé Partners? They increased in value by an average of only 36%.

Warren Buffett demonstrated conclusively that hedge funds couldn’t match the returns provided by the S&P 500 index. They didn’t even come close. Actively managed mutual funds aren’t much better. A majority of actively managed large-cap mutual funds have underperformed the S&P 500.

Despite the evidence to the contrary, investors keep pumping money into actively managed mutual funds (although index funds are rapidly gaining ground.) Is that optimism bias at work?

The Harry Markowitz model

Harry Markowitz won the Nobel Prize for economics in 1990 for his work in the area of risk management. According to Markowitz, investors need to diversify their portfolios. They should aim to select a group of financial securities that collectively carry a lower level of risk than any single component of the portfolio.

In other words, Markowitz recommended that every investor should attempt to maximize returns at a given level of risk. His Modern Portfolio Theory is based on an elaborate model using different statistical measures. It explains why the return an investor earns is not as important as how each component of the portfolio performs in relation to the other investments.

However, when investing his own money, Markowitz adopted a much simpler approach. When allocating his retirement funds, he split his money equally between stocks and bonds.

Why did he do that?

Explaining his simple asset allocation strategy, Markowitz said that he didn’t want to miss the gains that a rising stock market offers. And the investment in bonds? That was his way of preserving the value of his portfolio if the market crashed.

The bottom line

Instead of trying to analyze and overcome the illogical investment decisions that they often take, armchair investors may be better off adopting a more straightforward approach.

Deploying their money in an index fund or dividing it equally between stocks and bonds could work well for most people.

Remember that it’s difficult for investors to behave rationally.

Even economists who are Nobel laureates allow their emotions to dictate their investment decisions from time to time.

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