Australasian Investment Review
30th May 2005
Human Behaviour – The Greatest Barrier To Trading Success
Have you ever held on to a stock too long, in the vain hope it would return to the price at which you bought it, even though you knew in your heart of hearts this was unlikely to happen? Well, you’re not alone.
Human beings are simply not rational creatures. If they were, then no one would have ever made money out of selling pet rocks. Yet someone did, which only emphasises the long held belief that a fool and his money are easily parted.
One of the most visible examples of this adage at work is the stock market. That is not to necessarily say that the market is riddled with fools. But with the benefit of hindsight, any investor would be lying if they purport to have never made one investment decision which they later realised to be foolish. At some point, rational behaviour gave way to irrational behaviour, resulting in either money, or opportunity, being lost.
Whitney Tilson is a highly successful US money manager, and a student of human behaviour. His recent presentation, entitled Applying Behavioural Finance to Value Investing, draws upon several columns he has written for the likes of the Wall Street Journal, in which he identifies and examines those traits of human nature that turn a seemingly rational investor into a luck-be-a-lady irrational gambler.
Be warned, we are all about to enter a hall of mirrors and may not like what we see.
Tilson believes that investment success requires far more than intelligence, good analytical abilities and proprietary sources of information. Equally important is the ability to overcome the natural human tendencies to be extremely irrational when it comes to money. As Warren Buffet puts it, "Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing."
One piece of classical research of the 1950s revolved around a group of pigeons who quickly learnt that they could earn a reward of birdseed if they kept pecking on a feeding bar. When the birdseed is cut off, the pigeons will keep pecking the bar until realisation sinks in that no more reward is available. They will then abandon the process in a uniform manner.
However, if random element is introduced, such that reward is forthcoming sometimes but not always, the pigeons encounter a mind-spinning quandary. The rewards are there, but they can’t get their heads around how they can be consistently earned. The result in any number of experiments is that the pigeons keep returning to the bar over and over, even after the rewards have been terminated altogether. Eventually, they drop dead from exhaustion.
Fair enough, you say, but then humans are somewhat smarter than pigeons.
Consider another experiment, by the same Nobel Prize-winning economist, Vernon Smith, in which a group of participants would trade a dividend-paying stock, the value of which was clearly laid out for them.
Invariably, a bubble would form, with the stock later crashing down to its fundamental value. One might expect that the participants, having suffered terrible losses, would have learned not to speculate. Yet when they gathered for a second session, still the stock would exceed its assigned value, though the bubble would form faster and burst sooner.
The conclusion drawn is that the lesson learnt by investors the first time was not: "don’t speculate", but rather: "sell more quickly once the bubble starts to burst". Of course this doesn’t work either, as few people accurately time the top and everyone tends to head for the exit at the same time.
Says Smith, "They always report that they’re surprised by how quickly it turns and how hard it is to get out at anything like a favourable price". It is only when the session is run a third time that the stock trades near its fundamental value, if at all.
So are humans that much smarter than pigeons?
Tilson suggests that one of the biggest problems facing human investors is that they tend to be overconfident in their view of things. Not just "robustly", but "wildly" overconfident. He provides the following statistical examples:
- 82% of people say they are in the top 30% of safe drivers;
- 86% of Harvard Business School students say they are better-looking than their classmate;
- 68% of lawyers in civil cases believe their side will prevail;
- 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed;
- Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement, and how much the average person in the room would have. The average
figures were $5 million and $2.6 million respectively.
In regards to the last example, apparently it doesn’t matter who the audience is, the ratio is always about 2:1.
It is such irrational overconfidence that Tilson believes gets investors into trouble. Moreover, it turns out that the more difficult the task (such as predicting the price of a stock), the greater the degree of overconfidence. And professional investors – the so-called experts – are generally even more prone to overconfidence as they have theories and models which they tend to overweight.
Tilson explains overconfidence by suggesting that people generally remember failures very differently from successes. Successes were due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus people will tend to believe that with a little better luck or fine-tuning, the outcome will be much better next time.
Overtrading is a fine example of overconfidence, Tilson suggests. In a study of 78,000 individual investors at a large US discount broking house during 1991-96, average annual turnover was around 80%. The least active quintile, with an average annual turnover of 1%, scored a 17.5% annual return. The S&P return was 16.9% over the same period.
The most active 20% of investors, with annual turnover of greater than 100%, scored a 10% annual return.
The authors of this study thus concluded that "trading is hazardous to your wealth". And perhaps more thought-provokingly, another study by the same authors showed that investors who switch to on-line trading, hence cutting out the human broker in between, suffer significantly lower returns.
Detrimental overtrading is also evident in research conducted on the movement of funds between fund managers. Between 1984 and 1995, the average US equity fund returned 12.3% against the S&P’s 15.4%. Yet the average individual equity fund investor earned only 6.3%.
The only conclusion is that individual investors were moving their money around, chasing the best returns. The other conclusion is that this doesn’t work.
Tilson’s conclusion is that investors have an awful, unshakeable habit of piling into the hottest investment fad at precisely the wrong time. If there’s one thing as certain as death or taxes, says Tilson, it’s that investors will chase performance, almost always to their detriment.
Whereas chasing performance irrationally may be one example of detrimental human behaviour, the real problems start when one considers the other side of the equation – selling. Possibly the hardest thing an investor has to do is to make a decision to sell at a loss.
As I suggested at the very beginning of this article, the heart might know when it’s time to get out, but the head is usually on its own trip.
One’s inability to admit that one may have made the wrong decision is part of the problem. As Tilson suggested, we attribute success to ourselves, but failure to outside forces. Nevertheless, in selling situations, the real demon is the tendency to put one’s head in the sand in the irrationally desperate hope that when one pulls it out again, it will all have been just a bad dream, and the stock is back where it was.
How well we know this is misdirected blind faith, and how often we do it again.
Tilson makes the perfectly rational suggestion that an investor should always step away from their portfolio and consider, "would I buy that stock now?" If the answer is no, then why hold on?
Tilson suggests another extremely sensible exercise (he’s kind of annoying like that). Take your portfolio, and pretend you’ve turned it all into cash.
Now, from a totally fresh position, decide upon the portfolio you would really like to have now. Is it different? Yes? Then why the hell is it?
As Tilson so poignantly points out, keep in mind that a stock doesn’t know that you own it. Its feelings won’t be hurt if you sell it, nor does it feel any obligation to rise to the price at which you bought it so that you can exit with your investment – not to mention your dignity – intact.
Humans don’t only turn into irrational reprobates at the thought of selling at a loss either. An equally unjustifiable opposite is the blind hope that a stock may return to a price where you wished to buy it in the first place, having since moved up. If your rational mind can suggest that a stock is worth buying up to a certain price, then go ahead.
The same philosophy can be applied on the downside. Just because a stock you’ve bought falls in price, it doesn’t mean you must be wrong. Some short term influence may be at play, and the reality is that a dip is an opportunity to buy more at an even better price.
Tilson refers to this as "anchoring". That is the tendency to stubbornly stick to your original evaluation without taking time to step back and review any new information, or objectively analyse any specific force acting upon a stock price.
To recap, the lesson so far is: don’t get swept up into chasing a stock, but don’t be too stubborn to increase a buying price. Don’t be foolish enough to hang on to a stock when it’s fallen, but don’t sell if you still believe in it. And don’t be overconfident for no good reason. It’s all very simple, isn’t it?
Of course it’s not. But then Tilson is not trying to be sanctimonious. His writings are littered with his own self-confessed pathetic examples of when he made exactly all the wrong decisions, for exactly all the wrong reasons.
Tilson’s guide to rational investment, hewn from years of good and bad experiences, is this:
- Don’t anchor on historical information, perceptions, or stock price;
- Keep an open mind;
- Update your initial estimate of intrinsic value;
- Erase historical prices from your mind; don’t fall into the "I missed it" trap;
- Think in terms of enterprise value, not stock price;
- Admit and learn from mistakes, but learn the right lessons and don’t obsess;
- Put your original investment thesis in writing so you can refer back to it;
- Sell your mistakes and move on; you don’t have to make it back the same way you lost it;
- Be careful of panicking and selling at the bottom;
- Don’t get fooled by randomness
- You are a child of the universe, no less than the trees and the stars – you have a right to be here. And whether or not it is clear to you, no doubt the universe is unfolding as it should.
Actually the last one is from Max Uhrmann’s Desiderata, but I thought it was apt.