50 Psychological Experiments for Investors
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50 Psychological Experiments for Investors

Mickäel Mangot

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eBook - ePub

50 Psychological Experiments for Investors

Mickäel Mangot

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About This Book

Great book! Mickäel has done a great job of explaining the insights from over 50 groundbreaking psychological experiments. You will learn how to avoid many of the psychological mistakes made by most investors. He teaches you to watch out for overconfidence and the momentum bias to avoid large losses. He helps you to understand how your social relationships can change your asset allocation risk profile. Forearmed is forewarned. If you apply Mickäel's insights, you will improve your investment performance.

Paul Stefansson
Executive Director, UBS AG


Why are investors sometimes their own worst enemies? As this eminently readable book shows, all sorts of biases affect investors' judgments, ranging from sheer ignorance and emotions to overconfidence or aversions, from selected short-term memory to undue generalizations. Building on the expanding literature in behavioral economics, the experiments reported here shed a useful, often funny, light on the implicit rules investors use to form their judgment and decisions. This book will definitely help you make wiser investment decisions!

Christian Koenig
Director, Asian Center, ESSEC Business School


Mickäel Mangot provides a fantastic tool that individuals as well as financial advisors can immediately apply to their portfolios. This book's success lies in its superbly easy-to-use format: Mangot demystifies the technical terminology of behavioral finance by linking everyday behavior to the world of investing. So while the human examples are enjoyable and interesting (you'll chuckle when you recognize these traits in yourself), he deftly explains how these very human biases lie at the root of 57 simple but very damaging investment mistakes. Most importantly, each conclusion provides a concise, sensible summary to help you correct—and improve—your investment decisions.

Philippa Huckle
CEO, The Philippa Huckle Group

This is an insightful book that forces one to question one's own financial behavior. 50 Psychological Experiments for Investors covers different topics such as savings, equity investment and property investment. The portrait of the investor presented here is harsh but can be highly profitable for anyone who recognizes that he or she is vulnerable to misjudgments and misguided emotions. A must-read for any self-questioning investor.

Jacques-Henri David
Vice Chairman Global Banking, Deutsche Bank

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Information

Publisher
Wiley
Year
2012
ISBN
9781118580349

CHAPTER 1

A Love of Anecdotes

How We Choose Information on Fallacious Criteria

SUMMARY
1. Why do you think you have to invest in the stock market when prices have skyrocketed?
Momentum bias
2. Why do you buy stocks when the market has gone up and bonds when the market has gone down?
Momentum management
3. Why are you sure that everyone agrees with your view that the market is going to go up?
False consensus
4. Why does Google’s success make you want to invest in high-tech?
The availability heuristic
5. Why has your stock portfolio only gained 5 percent this year when you are sure it has earned twice as much?
The confirmation bias
6. Why is it that on moving to the boonies you rent an overly expensive apartment?
Points of reference

1. Why do you think you have to invest in the stock market when prices have skyrocketed?

Momentum bias

Suppose—and the truth is not far off—that real estate prices had increased by 15 percent in 2004, 2005, and 2006. Do you think that the probability is high that they will post the same hike in 2007? Now suppose that the advance had been only 3 percent per year over the past three years. Is it still just as probable, in your opinion, that 2007 will finish with an increase of 15 percent?
Investors often think that what has occurred in the recent past can reoccur in the near future with a probability very much higher than is realistic. This behavior may originate in the failure to understand that when a random phenomenon is stable, it is necessary to observe it over a long period of time in order to obtain an accurate picture of its probability distribution. A practical consequence is that the tendency to give excessive weight to recent information distorts expectations regarding return on investments. It seems that individual investors are optimistic when the markets are bullish and pessimistic when they are bearish. De Bondt (1993)1 used a weekly survey conducted by the American Association of Individual Investors (AAII) during the period from 1987 to1992 to assess the predictions of investors. The results demonstrate that their predictions for the movements in the Dow Jones index for the following six months are directly tied to the performance of the index during the week prior to the survey. The balance of opinion (optimist-pessimist) widens on average by 1.3 points for each percentage point the Dow gains during the week preceding the survey. More generally, the survey shows that the feelings of investors about the index depend on the market performance over the previous six months.
In the same vein, a study by the Gallup polling institute, ordered monthly by UBS PaineWebber, shows that the expectations of individual American investors over the years 1999–2002 followed the fall of the markets (see Table 1.1). As the American market was falling, the forecasts of the investors for the following year were being revised downward.
Table 1.1 Annual forecasts of American individual investors
Source: UBS PaineWebber/Gallup Survey of Optimism of Individual Investors.
Year Annual change in the S&P 500 Forecasts of investors for the following year(on Dec. 31)
1999 19% 15.3%
2000 −10% 10.5%
2001 −13% 8%
2002 −23% 5.9%

Conclusion

Certainly the momentum bias arises as much from ignorance of the elementary laws of probability as from lack of information on historic returns. Increases of 15 percent in real estate prices or of 30 percent in the stock market are extreme phenomena that are much less probable than more modest changes conforming to historical averages. Betting on them is like betting on snow in Beijing in October. It is possible, but surely not very probable, even when July, August, and September have been quite cool.

2. Why do you buy stocks when the market has gone up and bonds when the market has gone down?

Momentum management

If momentum bias affects the expectations of investors, it also changes their management practices by encouraging investment based on the performance of investments in the short-term. The better the recent performance of investments considered risky, such as stocks, the more they attract investors. Similarly, when it comes to choices among different stocks, those which have gone up the most are most often put into portfolios.
Bange (2000)2 has compared the results of the weekly survey by the AAII on the expectations of individual investors and those of the monthly survey by the same association on the distribution of assets (stocks/bonds/liquid assets). It too found that the predictions of individual investors were derived from past performances and that the weight of stocks in portfolios of investors increased accordingly. Thus the more markets go up, the more the individual investors are optimistic about future performance and consequently increase their exposure to stock markets. The more markets go down, the more investors are pessimistic and prefer to invest in bonds or to keep liquid assets.
In a study on the differences between investors based on the transactions of 41,006 clients of a large American brokerage house, Dhar and Kumar (2001)3 sought to classify individual investors into “momentum” investors (who believe in following the movements of the market) and “contrarian” investors (who believe in the correction of movements; see Table 1.2). They observed the behavior of stocks during the days and the months preceding the transactions that the investors made (buying or selling). They determined that on average the investors bought securities that posted significant gains over periods ranging from a week (+0.62 percent) to three months (+7.26 percent). Among the 41,006 clients followed, 12.6 percent systematically bought securities which had gone up over the past month (strictly momentum investors). The proportion of strictly contrarian investors was slightly less (10.4 percent).
Table 1.2 Recent performances of securities bought by individual investors (1991–1996)
Source: Dhar and Kumar (2001).
Timeframe Average Median
1 week 0.62% 0.25%
2 weeks 1.12% 0.59%
1 month 2.22% 1.07%
3 months 7.26% 4.47%

Conclusion

Ultimately, the more or less well motivated tendency to buy securities that have increased the most, turns out to be quite sound. The researchers identified a short-term momentum effect in many stock markets. Jegadeesh and Titman (1993)4 describe a momentum effect for American stocks for periods of three to 12 months during the years 1965–1989. For example, the best performers (winners) over nine months reported on average a return higher by 9.85 points in the nine months following than did the securities which had posted the worst performances. The momentum effect is more important for securities with extreme performances and for the small caps. It occurs as well on the European and some emerging markets.

3. Why are you sure that everyone agrees with your view that the market is going to go up?

False consensus

Momentum bias is the temporal manifestation of the bias of representativeness which encourages the individual to deduce the general rule from examples which are only anecdotes. False consensus is the social aspect of this bias. Numerous studies, beginning with those of Ross, Greene, and House (1977),5 have shown that there is a false consensus effect which pushes individuals to overestimate the generality of what concerns them. Thus, someone who has chosen A from among the set {A ; B} will expect a greater frequency of the choice A than those who have chosen B. If you prefer French fries to green beans, you have a greater chance of thinking that a stranger prefers fries to green beans as well. Similarly, someone who has experienced a remarkable event will feel that this event affects more people than it does in reality. If you have been mugged twice in the past three months, and never before, you will think that crime is on the rise. Yet, your personal circumstance may not be representative. In financial matters the false consensus phenomenon leads to a bias in the evaluation that is made of the consensus in the financial community.
Based on the responses to a questionnaire of 226 professors and doctoral students, Welch (2001)6 has demonstrated the existence of false consensus in the appraisal of the risk premium of stocks, that is, the difference between their future return and that of risk-free bonds. He asked the respondents to give both their personal assessment and their estimation of the consensus (the average opinion of the market) for the risk premium over periods of 1, 5, 10, and 15 years. He found a strong correlation between the personal expectations of the individuals questioned and their perception of the consensus. The more a subject is optimistic about the level of risk premium, the more he thinks that the market, whose opinion is expressed by the “consensus,” is optimistic too. From this result, Welch suggests that financiers form their valuation of the consensus from their personal assessments. In general, they think that the consensus is slightly more optimistic than they are.

Conclusion

The size of the false consensus phenomenon depends greatly on the context. According to psychologists, the effect is all the more important if:
– the individual is in contact with others who are like him in many ways (friends, colleagues);
– he perceives his reactions as arising from the situation (“state” of the market) more than from his personal frame of mind;
– his attention is focused on a single factor (the hike in the market) rather than on several;
– he is very confident in the correctness of his stance; and
– the stakes are important (his money) and constitute a threat for him (self-esteem, reputation).

4. Why does Google’s success make you want to invest in high-tech?

The availability heuristic

In order to make judgments, individuals are helped by simple facts which are easily brought to attention from memory. The judgments are biased by this immediately available information, if not totally determined by it. The availability heuristic, documented by Tversky and Kahneman (1973, 1974),7 encapsulates the general principle by which individuals evaluate the probability associated with an event as a function of the ease with which examples of such an event come to mind. For example, they asked 152 English-speaking individuals whether words beginning with K or those with K as the third letter were more numerous. (Words with less than three letters were excluded). Out of the 152 persons questioned, 105 opted for words with K in the first position, while in fact these are half as numerous as words with K in the third position. This result is explained by the greater ease with which one can find examples of words beginning with K as compared to words with K in the third position. Other examples can be found in daily life. The driver who has just witnessed an accident will drive more carefully, for the time being, even though he knows that the probability that he will have an accident has not suddenly gone up. Only the subjective probability that he associates with being involved in an accident has temporarily increased. In financial matters, the heuristic of availability can play a role when the individual reasons by analogy rather than by logic to come to a decision and take a position. This is notably the case during initial public offerings when investors participate in introductions just because previous introductions of “similar” firms have gone pretty well in the recent past. There was a temptation to buy shares of EDF (the French electricity utility) at its appearance on the French Stock Exchange only because the introduction to the Exchange of GDF (the French gas utility), which was perceived as a similar company, had gone well. And this despite the fact that companies are very different, as are their prospects.
Gregan-Paxton and Cote (2000)8 studied how investors predicted the results for a target company selling its products on the Internet from the performance and characteristics of three other companies. They used 259 members of investment clubs which were divided into two groups; one had to predict the performance of the target company without an obviously similar company in the database; the other group had a comparable company, at least in its superficial characteristics, in the database. They compiled the predictions according to the arguments that the subjects made in explaining their analysis. They were thus able to divide the subjects into those who from the examples were able to imagine the keys to success on the Internet and those who were not able to discover the obvious principle. It emerged that subjects who were not able to uncover the principle at work on the Internet had employed a shallow reasoning by analogy process and then predicted that the performance would be comparable to that of the company which was superficially the most similar to the target company. Those who had found the operative principle had, moreover, applied the rule in responding, using a structural analogical reasoning. In a less intuitive way, it came out as well that among the individuals who had discerned the principle, fewer used that principle, which they had understood, to arrive at their answers when the database included a company superficially similar to the target company than when it did not include such a company. These results tend to show that, on the one hand, analogical reasoning serves as a strategy of second choice when there is nothing else to use in order to make a decision and, on the other hand, that in the presence of a similar company, certain individuals willingly ignore the rules that they have understood and place them on a lower level when arriving at their predictions.

Conclusion

Starting from an example to find the general principle is a perilous undertaking. Even if it is easier, reasoning by analogy does not give as good a result as reasoning by logic. Having examples in mind of noteworthy facts concerning the performance of investments can engender ideas for investing. However, one must follow up and go more deeply into these ideas to learn whether the example which stimulated the idea was representative or only anecdotal.

5. Why has your stock portfolio only gained 5 percent this year when you are sure it has earned twice as much?

The confirmation bias

The bias of conservatism explains the tendency to overvalue information that confirms an opinion and to minimize conflicting information. Numerous marketing studies have identified this bias. For example, Russo has carried out an experiment in which he asked students to choose between two restaurants from a comparison of their menus. The experiment was designed in such a way that, when the comparison was made considering the whole menu, the group split itself equally between the two restaurants. The balance, however, was broken when the choice was made after a detailed comparison, dish by dish. Then 84 percent of the students opted for the restaurant which obtained their preference after the comparison of the first pair of dishes.
The confirmation bias goes further, stating that individuals expressly look for information that supports their opinions and actions and scrupulously avoid being confronted with contrary information. For example, after the purchase of an automobile, it is usual not to pay attention to the advertisements of competitors’ models in order not to question one’s choice. The confirmation bias comes from a general attitude of humans to try to avoid moments of doubt. The theory of cognitive dissonance (Festinger, 1957)9 postulates that an individual acts in a way such that there be no inconsistency between the information he receives and his opinions. Information in dissonance with an opinion (or belief, or behavior, or others) creates an unpleasant condition for the individual. In order to avoid it, the individual tries to reduce the disaccord by modifying one, or both, of the two contradictory positions. Searching for confirming information is one of the strategies he can set up to solidify his initial opinion. Avoiding discordant information is the other.
Goetzmann and Peles (1997)10 asked two groups of investors in mutual funds to give the absolute performance of their funds and also their performance relative to the market (see Figure 1.1). The first group was comprised solely of architects and the second of members of the AAII. The second group, therefore, held more information on the market and was more interested in the performance of its investments. In the end, both group...

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