Regular readers of my books and articles are likely well aware that I’m a big fan of the field of behavioral finance. In fact, I try to read everything I can on the subject. The first half of my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” discusses many of the investment errors behavioral economists have found, in addition to explaining how you can avoid them.
While the financial establishment focused on developing “normative” theories describing how investors act as “Econs” (who make rational choices leading to optimal decisions), behavioralists instead focused on “descriptive” theories describing not how investors should act logically, but how they actually do act as human beings (who are subject to all kinds of biases that lead to less-than-optimal choices).
Exploring Biases And Aversions
A new book by Richard Thaler, “Misbehaving,” provides many examples of such behavioral anomalies, the study of which has greatly improved our understanding of how markets work and how decisions are made. Thaler, a professor of behavioral science and economics at the University of Chicago, is considered one of the founding fathers of the behavioral finance field (along with Daniel Kahneman and Amos Tversky).
Among the many phenomena that Thaler discusses are the endowment effect (we value things we own more highly than things we don’t yet own), hindsight bias (after the fact, we think we always knew a given outcome was likely, if not a foregone conclusion), confirmation bias (the tendency to search for, interpret or recall information in a way that confirms our preexisting beliefs or hypotheses) and prospect theory (the hurt from losses is greater than the pleasure derived from equivalent gains).
Hindsight bias can lead to overconfidence, and prospect theory can lead to risk aversion when it comes to gains but risk-taking when it comes to losses. Prospect theory also includes loss aversion—or myopic (short-sighted) loss aversion—and is considered by Thaler to be the single most powerful tool in the behavioral economist’s arsenal. His book discusses several studies demonstrating why he believes this to be the case.
Solving The Mystery Of The ERP
Thaler also details why he believes prospect theory provides an explanation for what’s known as the equity risk premium (ERP) puzzle. The ERP is considered a puzzle by many market observers because the magnitude of the historical equity risk premium has been much greater than could be predicted by normative models.
Rajnish Mehra and Edward Prescott first coined the phrase in their 1985 paper, “The Equity Premium: A Puzzle.” While the authors found an ERP of roughly 6 percent, the largest premium their normative model could predict was just a small fraction of that amount. Prospect theory—specifically, myopic loss aversion—provides an answer.
Thaler and other researchers have found that investors tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This creates a problem for investors who check the value of their portfolios on a frequent basis. Consider the following.
Based on the historical evidence for the S&P 500 Index from 1950 through 2014, investors who check their portfolios on a daily basis can expect to see losses 46 percent of the time and gains 54 percent of the time. However, even though these investors see gains more often than losses, because we tend to feel the pain of a loss with twice the intensity that we feel joy from an equal-sized gain, the more frequently we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will show an average of -38 (or [-46 x 2] + [54 x 1]).