In our world of personal finance advisory, it is often believed that managing investor behaviour adds far greater value than picking the right investments. This is a result of the development of a new field of economics called Behavioral Economics. It is indeed new in the grand scheme of things as this article reminds us that the Nobel prize winning Daniel Kahneman and his research partner Amos Tversky first published their paper as ‘recently’ as 1971.
“Behavioral Economics, aka Behavioral Finance, was the app update to economics. Traditional economics had blind spots, treating human beings as perfectly rational when we clearly are not. Some people insure against UFOs.
These thinkers found the blind spots. Their exciting new theory explained why we did weird things with money: loss aversion (risking big losses to avoid small ones), mental accounting (hoarding credit card points for vacation instead of treating all money the same), or prospect theory (the Aliens).”
Alien insurance is apparently a real thing: “Over 100,000 Americans have Alien Abduction Insurance. GEICO sold some. Lloyds of London underwrote 20,000. Two claims were paid.”
Whilst Behavioural economists would call this as irrational, the author argues why they might be missing a point or two “Behavioral Economics has developed two blind spots of its own.”
First, its claim that making decisions based on lived experience is crazy: “Henry Wallich, a 1970s-era Fed Governor, whose childhood experiences with German hyperinflation left him relentlessly hawkish. Wallich treated his lived experience with inflation as more important than the data presented to him. Nancy Teeters, his colleague, offers the supposed voice of modern reason: “Henry Wallich was our real problem.” But Wallich was right and Teeters was wrong. Fashionable revisionist history says the Fed didn’t need to take rates to 19% to crush inflation. Yet for a decade, every time inflation abated and the Fed eased policy, prices rose even higher”
He goes on to highlight the severe implications of persistently high inflation on various aspects of American economy and society through the 70s.
“Behavioral Economists argue that people are crazy because we put lived experience above data. But lived experience is data, the previous results from an experiment applying a strategy against uncertainty in real time. N = 1, sure, but not 0.
There are times when the most rational thing to do is not to optimize for the likely, but to protect against the overwhelming scale of the unlikely. Those who’ve seen the bad event know this, and behave accordingly.
Humans, not wrongly, sometimes understand that it is the impact of the event, not its likelihood, that matters. If the aliens come, insurance does you no good. If the layoffs do, an overabundance of cash may be sub-optimal, but is it crazy?
To quote Nassim Taleb, “The market is like a large movie theater with a small door. And the best way to detect a sucker is to see if his focus is on the size of the theater rather than that of the door.”
Blindspot #1: dismissing the scale of the improbable.”
Second, specific to personal finance, that investments will inevitably do well in the long term: “Why? Because, from 1982 until early this morning, we lived through the longest bull market in human history. For the entire lives of Behavioral Finance scholars, the stock market has gone up and to the right, and the few times it did not strategies like 60/40 stock/bond splits offset the dips.”
The author argues that 40 years is too short a time and points to instances where investments haven’t worked well even in the long term.
“Markets, in this telling, are logical distributions of chance that cluster around a bright future.
But the future of the market was, and is, unknowable. Saying that the clear lesson of history is to trust the long term “rational” market outcomes is, well, wrong. The returns from institutions depend on the quality of those institutions, and for much of history the promise of compound returns were Gnostic gospels at best.
…There have been plenty of stretches where long-term investing failed. As I pointed out in my book, “Simply buying a house and saving 10 percent in stocks around 1870 would have left you wiped out four separate times. A recent study covering 125 years showed that Americans saving a whopping 20 percent of their annual incomes in stocks would have failed to survive retirement nearly half of the time. The only savings rate that never failed was over 40%.”
…Behavioral Finance clusters a few generations of long-term bull market growth and substitutes it for a theory of financial time.”
He then brings up Kahneman’s loss aversion theory and the glories and pitfalls of momentum investing: “Most naive stock pickers, he showed, sold winners but held on to losers, hoping prices would come back (the disposition effect). You should do the opposite because of the “well documented market anomaly that stocks that recently gained in value are likely to go on gaining at least for a short while.”
Winners keep winning, so keep them. Losers lose; ditch ‘em. This is statistically true, and one of the best documented investment strategies in finance.
Except when it isn’t.
From the CFA Institute: The Achilles heel of momentum, however, remains its crash risk. Momentum strategies are vulnerable to sharp reversals, particularly during market regime shifts. We document maximum drawdowns as large as –88%”
Nor does he leave mean reversion alone: “Behavioral finance’s great insight was that individuals substitute their own subjective lives for logic in decision making. But it then turns around and treats the recent past as the entire data set for predicting future outcomes, which are inherently not bound to that past. A person may be irrational to worry about a 10 Sigma event from the mean, but it is equally irrational to assume everything must hover near it forever.
The past does not get to tell the future what to do.
In history, the mean doesn’t pull. It has no gravitational force.”
In conclusion, he makes a couple of points worth noting:
“Probabilities don’t keep people up at night. Scale does. Acknowledge the rationality of the low probability, high impact worry.
…Sell downside protection, even when suboptimal: Yes, most hedges (lower performing assets, annuities, etc.) underperform bull markets. So?
Running with the bulls is exciting (in Pamplona or Wall Street), but have you ever tried running away from a bear?
Disclaimer – Berkshire Hathaway Inc. (owner of GEICO) forms part of the active holdings within the Marcellus Global Compounders Portfolio, a strategy offered by the IFSC branch of Marcellus Investment Managers Private Limited and regulated by the IFSCA. Accordingly, Marcellus, its employees, their immediate relatives, and clients may maintain interests or positions in these securities. Any reference to these companies is intended strictly for informational and educational purposes within the context of this discussion and should not be construed as investment advice.
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
