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Behavioral Errors Hurt Your Returns

by Daniel Kahneman

Behavioral Errors Hurt Your Returns Splash image

Daniel Kahneman is a senior scholar at Princeton University’s Woodrow Wilson School of Public and International Affairs and the 2002 winner of the Nobel Memorial Prize in Economic Sciences. His book “Thinking, Fast and Slow” (Farrar, Straus and Giroux) was published last fall. I spoke with him recently about the impact of behavioral errors on investment performance.

—Charles Rotblut, CFA

Charles Rotblut (CR): You opined as we sat down that individual investors should use index funds instead of picking their own stocks. Could you explain why?

Daniel Kahneman (DK): Well, there is research for that. The research I have in mind was done by my former student, Terry Odean, who is now a professor of finance at the University of California–Berkeley. He did a study of the decisions of individual investors who sell a stock and buy a stock, which means that they are not selling it for liquidity; they’re selling it because they believe the stock they sell is inferior to the stock they buy. There is no other reason.

Now, when you wait a year, and you look at the value, on average, of the stock that individual investors sell and the stock they buy, then you get a difference of 3.5%, roughly, almost 4%. So that means every action the individual investor takes has negative expected value. On average, they lose, and the more ideas they have, the more they lose. Women do better than men because they churn their accounts less. The real enemies of good returns are churning and lack of diversification. Individual investors fall for both of those. So that would be my advice: Avoid churning and avoid making decisions, because individual investors are really, by and large, not equipped to make the decisions.

CR: Is there a particular behavioral error that you have seen, in terms of what errors investors make or what is causing them to make errors?

DK: Sure. But it’s not an error that you can fix. They sell the wrong stock, and they buy the wrong stock. People tend to sell their winners and hang on to their losers. That is, they sell stocks that have done better than the price they bought them at. Now, this is a really bad idea, and it’s a bad idea because, by and large, there is short-term momentum in the market. Because there are large tax consequences, other things being equal, you should sell losers. But the tendency to stick with your losers and sell your winners is a very big deal. So that’s one thing.

Then, people buy the wrong stock. They tend to buy stocks when there is news, good news or bad news. And we know that institutions do better than investors because they do not respond in the same way to news. This is other work that Terry Odean and Brad Barber, a professor at the University of California–Davis, have done.

So, by and large, it’s unequivocal: If you’re an individual investor, you’re likely to lose when you buy and likely to lose when you sell. We also know that individual investors who follow funds tend to buy into a fund when it’s been doing well and tend to sell it when it’s low. So you can have a fund that is doing very well, but of course it fluctuates, and the average investor in that fund loses money. And there’s no contradiction, because the average investor buys at the wrong time and sells at the wrong time. It’s not something people should do.

CR: Do you think investors just want to be part of a herd, or is it that they’re overconfident?

DK: It’s mostly overconfidence. People think they can pick stocks, but in fact they can’t. They have a subjective feeling of confidence and certainty that is not justified by anything, and that’s what drives them to do it.

Investors also misremember their outcomes and misattribute their outcomes. So, in a rising market, individual investors tend to feel that they’re geniuses because the results are good. They blame the market when things collapse, but they take credit when things go well. This bias tends to make them overconfident and hyperactive.

CR: Do you think it’s hindsight bias? I know you wrote about that in your book, “Thinking, Fast and Slow.” Do you think they’re overestimating how well they’ve done in the past?

DK: Yes, there clearly is a selective memory of successes and failures so that, in addition to all the other biases, people get the wrong idea about how good they are. And they tend to exaggerate how well they are doing.

CR: I know you’ve also talked about overconfidence on the part of CEOs. Do you perceive that as also being a risk?

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DK: Well, it’s very clear that highly optimistic CEOs take more risks. Interestingly enough, there is evidence, which I think I cite in the book, that when a CEO who is highly optimistic takes over, the stock market responds negatively. So there is enough knowledge in the stock market to evaluate the fact that optimistic CEOs tend to take risks.

CR: In your book, you said that overconfidence also plays a role in mergers, correct? That mergers don’t tend to be profitable.

DK: Yes. By and large, mergers are not profitable on average. I think the dominant theory of that is still a theory by Richard Roll, from the University of California–Los Angeles. It’s an old theory known as “the hubris hypothesis.” You see the other company doing badly, you think that they are very poorly managed, and you are confident that you can manage their company better than they can. Well, it turns out that, on average, that isn’t really the case.

CR: Maybe the core of all these errors is that people think they’re better than average?

DK: Yes. Of course, people do think they’re better than average in many domains. Overconfidence has many sources. It keeps us cheerful, so it’s a very good thing. Optimists are healthier than pessimists, and they have a better time. But, in the financial domain, I would say, the individual investor has no business being there. And should they have to take professional advice, I would say that they should not take advice from optimists.

CR: So find an adviser who’s more of a pessimist?

DK: No, a realist! You know, having a CEO who is an optimist has certain benefits, because their enthusiasm is catchy. But having a financial adviser who is an optimist is completely useless.

CR: In your book, you talked about System 1 and System 2. Could you explain what those are?

DK: System 1 is intuitive thinking, which is most of what we do, I think. And System 2 is self-critical, reflective, deliberate thinking. And we feel we do a lot of that. But, in fact, much of what System 2 does is explain and rationalize and apologize for the choices and beliefs of System 1.

CR: And when people start panicking when the market takes a big drop, that’s System 1 taking over?

DK: Well, System 2 could also, not panic, but decide that if things are going badly, it’s time to get out. But, certainly there is an emotional component.

And beyond a certain point, when the world becomes highly uncertain, we tend to act as other people do. Herding tendencies are likely to be enhanced in periods of crisis, and that is going to cause a great deal of volatility.

CR: Besides indexing, what can people do to avoid making errors? Or, even if they are indexing…

DK: The real problem that most people have—which wouldn’t apply to your individual investors—is that they just don’t save enough. So that’s a problem. Individual investors are people who are saving. I would say not saving is the biggest problem.

And the errors that individual investors make are, for example, ignoring fees. It looks as if the fees account for so little of the variance. But fees are a sure thing, and they certainly erode your earnings over time.

CR: In terms of how investors evaluate their performance when they’re working with an adviser: I think you wrote about how people blame the leader in charge.

DK: Hindsight is very pernicious. So whenever something goes wrong, it is very likely you’re going to blame your adviser.

Hindsight and regret are something that financial advisers must anticipate. They’re really noxious, because hindsight and regret cause people to make mistakes—to overreact when things are going badly, and so on.

Daniel Kahneman is a senior scholar at Princeton University’s Woodrow Wilson School of Public and International Affairs and author of “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011).


Discussion

Orlan Gaeddert from CA posted over 2 years ago:

“Thinking, Fast and Slow” is a splendid book, very readable. Seems to me, however,that Kahneman has a quite superficial understanding of investing and investors. In any event, I found no grist there for my mill. As always, caveat emptor!


Paul Hopler from VA posted over 2 years ago:

There are other reasons for selling one stock and buying another. We are constantly reminded to re-balance, assure a good mix of sectors, obtain some foreign, mix of large and small companies, growth and value companies, sell a stock that has a low "rating" and assure a stock is not too prevalent. In most cases we sell a stock we really like and buy an inferior one to improve asset allocation as the author suggest. This reduces the accusation of poor choices.


Tim Burland from WI posted over 2 years ago:

The advice to invest in index funds rather than individual stocks seems like a reasonable approach to avoiding behavioral investing errors, but it may not be the best advice to achieve the other key target, minimizing costs. Let's say the average annual expense for mutual funds is 1%, and for index funds 0.2%; and a stock transaction is $8 ($16 round-trip buy-sell). Consider the holding period for mutual funds and index funds to be indefinite, and then consider three types of stock investor: (i) AAII Model Portfolio, currently with 27 stocks; (ii) A typical investor as cited in the related Steven Sears article holding 27 stocks for an average 3.27-year holding period (turnover ratio 30.58%); and (iii) An investor who holds 27 stocks for the five-year average typical of a market cycle (20% turnover ratio). For a $200,000 portfolio (perhaps the smallest you'd want for holding all 27 stocks in the AAII portfolio), five-year ongoing costs would then be:

Mutual Funds $10,000 (yikes...)
Index Funds $ 2,000 (much better)
27 Individual Stocks (including $20 for Kahneman's book):
Annual turnover 35.8% $ 681
Annual turnover 20.0% $ 452
AAII Model portfolio $ 948 (116 $8 transactions 2007-2011)

Investors with smaller portfolios will not show the same advantage for stock investments and may prefer index funds over mutual funds or stocks. But, as a portfolio gets larger, individual stocks gain a bigger edge over index funds on costs. Stock portfolios should thus do better than index funds if you can just let your System 2 do the thinking, and individual stocks give you other advantages such as better control over timing of realizing gains & losses, etc.


John Portwood from LA posted over 2 years ago:

Kahneman has an important message in his book for investors. It is that simple screening methods or checklists often deliver results that are superior to unguided human judgement.


Charles Strout from NY posted about 1 year ago:

I am huge fan of Professor Kahneman and the work he has done over the last 30 years. He has incredible insights into psychology and how it impacts investor behavior. I only suggest that he may be a bit too overconfident in his conclusion that all individual investors should index. Rather, I think that individual investors should take his research seriously and develop systems to guard against the biases that he elucidates. It would seem that his research could lead to opportunities as well as pitfalls.


Scott Sneddon from CA posted about 1 year ago:

The problem I have with this is the broad statement of the average investor will x, therefore all investors should do y.

There is a huge gap between the guy sitting next to me at work who has his money automatically going into some funds - he doesn't even know which funds - and someone who has taken the time to really understand the market and quite possibly might be very good at buying and selling stocks. The point of "average" is that it covers up the extremes, and you may very well have some great stock traders and others who aren't very good, and then you get your average.

So...who does this apply to? Who are these "average" people that the research was done on and what was their engagement level in investing and trading?

I really need the answer to that question to know if his research is useful.

The "average" person should not plan to be a pro football player, pro musician, or pro trader. But, there ARE pro football players, pro musicians, pro traders, and all the other "things that people can't do" but ARE actually able to do.

I'm not surprised by his conclusions at all, because most people I know just aren't that interested in following the markets closely enough to become good at picking stocks, but most people DO have retirement plans with stocks in them, so the result would seem to be really that most people aren't great at things they aren't very interested in (and don't know much about).

It would be interesting to see this research done on a subset of individual investors who "should" be able to pick good stocks and see if the thesis still plays out.

Out of my three portfolios, my highly-regarded index fund is by far the worst-performing and I will not be putting any more money into it. I'll add to the stock picks in my individual portfolio that are doing much better. Wait - I'm supposed to sell the ones that are doing good, right?;)

If this is true: "And we know that institutions do better than investors because they do not respond in the same way to news" then who is it that causes a stock to plummet 20% in minutes during after-hours trading? Individual investors are doing that? I doubt it.

There are some very good points made in the article, but I think they apply more to the general public than to the "individual investor," whatever that means. So be aware of these pitfalls, but don't waste your money on index funds...


Kermit Prather from FL posted about 1 year ago:

Suggesting people buy an index fund instead of stock isn't the answer either. Yes, index funds are “safer” but like anything else when to buy and when to sell is very important. But you make it sounds like it’s a no brainer.

The answer is proper education in how to pick stocks, index or any other investment. The stock market is the only thing I know where people will put thousands of dollars at risk without doing a single thing of educating themselves.

As one who does investment education, I am constantly getting people who say I don’t want to spend all that time to learn how to do it. I just want to know where to put my money. I tell them in that case put it in your pillowcase, it’s a lot safer.


Donald W Giffin from Missouri posted about 1 year ago:

I subscribe to nine report letters with various perspectives and I religiously read them. I am a full time invester.

I own about 70 stocks which I select on the basis of inherent value. I f a stock comes to my attention that is better than one I own, and a short term loss is not in the picture, I switch. I sell when I don't understand why losses occur in a particular stock or when I do understand and think the market is not very smart. I focus only on my own portfolio and make all my own decisions.

The article seems geared to rookie investers. Neverthe- less, the warnings seem valuable.


David Vornholt from HI posted about 1 year ago:

His comment about all of us not saving enough is well taken. But he does seem to be 'overconfident' in his own opinions and has a bias to the research he directs. This article also says that self education is futile. Anti AAII.


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