The key innovation in this presentation is an innovation in how we view the world of investors, which has important implications for investing. Behavioural finance helps us to recognize that not all investors are rational, which was an implicit assumption in traditional finance models such as the Capital Asset Pricing Model (CAPM).
Models such as CAPM assumed investors all have access to the same information, they update their beliefs correctly as they get new information and they make choices consistent with the classical notions of expected utility maximization. So if all investors are rational, then intrinsic values always equal market values, markets are always efficient and investors should simply buy and hold index funds.
However, if investors are not rational, then intrinsic values are not always equal to fundamental values. Behavioural finance helps to describe the kinds of deviations from rationality we might expect to see due to biases, heuristics and framing effects. Biases are the predisposition toward error, heuristics are rules of thumb and framing effects are the manner and setting of decisions.
We need to be aware of our decision-making biases, the heuristics that we often rely on and how we frame our decisions. Do we tend to be excessively optimistic and assume a stock that has done well in the past will therefore continue to do well? Are we overconfident in our investment abilities just like most drivers feel they have above-average driving abilities? Do we rely on rules of thumb to assess a company’s prospects and confuse what appears to be a “good company” with “good investments”? In terms of framing, do we recognize that we tend to put more weight on potential losses rather than similar-sized gains and behave in a risk-averse manner?
In terms of our reliance on simple heuristics, in a recent working paper called “Double Then Nothing: Why Individual Stock Investments Disappoint,” I test the impact of relying on a simple heuristic whereby investors are attracted to buying stocks that have recently doubled in price in anticipation of further gains. I show that a strategy of buying stocks that have recently doubled in price can lead to predictable disappointment for these investors and severe underperformance relative to the market (-28% over a four- year period), whereas investors who avoid relying on this simple heuristic are likely to perform as expected, on average similar to the overall market. This “doubling variable” is a significant predictor of future price reversals in addition to past performance per se, as uncovered in a classic 1985 “overreaction” study by DeBondt and Thaler. Thus based on this study investors can become aware of the dangers of relying on simple heuristics and can avoid disappointment in investment returns.
So the more we are aware of our biases and work toward de-biasing, then the better we can make investment decisions. For example:
- Understand why you are investing;
- View decision-making as widely as possible;
- Set investment criteria based on sound research;
- Diversify your investments;
- Accept losses and treat sunk costs as sunk; and
- Think long-term.
Ultimately, you need to take a disciplined approach to investing.
Steve Foerster, Professor of Finance, Ivey Business School, University of Western Ontario.