For decades, the prevailing view of financial markets was one of rational actors creating efficient prices. In recent years, particularly in the wake of the GFC, investors have increasingly adopted a very different view of how markets operate. Loss aversion bias, anchoring, and herding (among others) have all become popular topics of discussion for fund managers, economists, psychologists, and more recently, even Hollywood movies.
You may recognise Professor Richard Thaler from his cameo in The Big Short (2015), but far more importantly, he is the 2017 winner of the Nobel Memorial Prize in Economic Sciences. He’s now the second behavioural economics specialist to win the prize, after Daniel Kahneman won in 2002.
Following Thaler’s win, we reached out to four fund managers with a series of questions to help readers better understand the world of behavioural finance and how investors can utilise its lessons.
In their responses, our contributors answered three questions. 1) What's the most powerful lesson to take from the study of behavioural economics, and how can everyday investors apply it to their processes? 2) How does your firm use the principals of behavioural economics in its investment process? 3) Can you share a current example where markets have ‘anchored’ to old information to create a significant mispricing?
Responses come from Chad Slater, Joint Chief Investment Officer at Morphic Asset Management; Nick Kirrage, Fund Manager at Schroders; Simon Shields, Principal at Monash Investors; and Mike Taylor, Chief Investment Officer at Pie Funds.
But before we get into that, first, some of the basics.
11 essential terms:
Anchoring – our tendency to use our initial exposure to a fact or number as a reference point for later judgements, regardless of the relevance of the information.
Choice overload – when presented with many choices, we are inclined to oversimplify or make no choice at all.
Confirmation bias – our tendency to place more weight on information that confirms our existing opinion.
Endowment effect – we place a higher value on something we own than something we don’t.
Goldilocks bias – the desire to compromise, even when it’s not the best option.
Herding – the tendency to ‘follow the crowd’. A critical factor in the creation and destruction of bubbles and busts.
Hindsight bias – when we convince ourselves that we ‘knew it all along’.
Loss aversion – we tend to be more interested in avoiding losses, than achieving gains.
Narrative fallacy – when we make up a story to explain an unpredictable event. This is particularly common when explaining daily or weekly market moves.
Recency bias – our tendency to better recall information that we have seen more recently.
Sunk cost fallacy – our tendency to want to hold on to paper losses in the hope of recouping them. A close relative of Loss Aversion Bias.
If it feels good, it probably isn’t
Nick Kirrage from Schroders encourages investors to ‘tune out the noise’. He says that the only thing we can predict about the economy, is that predictions will be wrong, so we must avoid placing importance on forecasts. In his example, he discusses one sector that is still affected by negative sentiment following the GFC. (VIEW LINK)
Strategies for staying ahead of the herd
Mike Taylor from Pie Funds cites an age-old piece of wisdom; “the market can stay irrational longer than you can stay solvent.” He suggests investors apply a simple test to avoid being caught up in fads like Bitcoin. In his example, he discusses an ASX small-cap where the market focussed too heavily on the short-term. (VIEW LINK)
Behavioural economics in theory and practice
Simon Shields from Monash Investors thinks that investors should pay close attention to signals from management in the way they disclose information, as this can send strong signals. For his example, he discusses a short position in New Zealand’s Sky Television, where conservatism bias allowed them an opportunity to profit from a falling stock price. (VIEW LINK)
Understanding your inner chimp
Chad Slater from Morphic draws on lessons from a book called The Chimp Paradox, stating that “your brain makes decisions that are not always in your best interest.” It’s important to learn to control your ‘chimp’ because it never goes away. His example of anchoring in action is a little ‘out of the box’ – perhaps one the next Fed President should take note of. (VIEW LINK)
Bloomberg recently published a list of five papers and books to further your understanding of Thaler’s work. (VIEW LINK)
Bri Williams is a CPA with a degree in Applied Psychology, and she’s published an extensive glossary of terms associated with behavioural economics. (VIEW LINK)
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For further reading, check out Hamish Douglass' 2-part article: "10 cognitive biases that can lead to investment mistakes" at https://cuffelinks.com.au/10-cognitive-biases-investment-mistakes-pt1/ and https://cuffelinks.com.au/10-cognitive-bias-can-lead-investment-mistakes-part-2/