The Securities and Exchange Commission has launched an investor education site, investor.gov that includes a comprehensive summary of what we’ve learned over the last 30 years about how we investors behave and the mistakes we make. This Library of Congress report published last August, Behavioral Patterns and Pitfalls of U.S. Investors, manages in sixteen pages to highlight some of the most important insights of the work of leaders in this academic field like Terrance Odean, Richard Thaler, Daniel Kahneman, Meir Statman, and many others.
The Role of Behavioral Finance
Nestled into a site that is largely a primer for new investors, the study is an interesting acknowledgement by the top securities regulator that there’s value to be found in better understanding our own true investing selves.
Other parts of Investor.gov are more hands-on. There are worksheets to fill out, including one that helps you calculate your net worth. There’s a run down of the ins and outs of how a broker executes trades, links to regulator records of advisors’ enforcement histories, and another to the SEC data base for stock research along with a detailed explanation of what different filings companies make and what might be interesting in them. Another page of links leads to more detailed SEC reports on complicated topics like variable annuities and various forms of fraud. The site even includes an explanation of why citizens should invest.
But to understand how we invest and how we could invest better, Behavioral Patterns and Pitfalls of U.S. Investors is a singular find. In a nutshell, writes researcher Seth L. Elan:
Behavioral finance holds that investors tend to fall into predictable patterns of destructive behavior. In other words, they make the same mistakes repeatedly. Specifically, many investors damage their portfolios by underdiversifying; trading frequently; following the herd; favoring the familiar (domestic stocks, company stock, and glamour stocks); selling winning positions and holding onto losing positions (disposition effect); and succumbing to optimism, short-term thinking, and overconfidence (self-attribution bias).
Here is a not random walk down the history of behavioral finance and its findings Links to most of these papers and a far more detailed description are available in the paper.
- Princeton’s Daniel Kahneman and Stanford’s Amos Tversky apply their Prospect Theory to investing and find investors pay too much attention to gains and losses. We are excessively risk averse and focus to our own detriment on avoiding loses over achieving gains.
- Later Kahneman teams up with Charles Schwab & Co. researcher Mark W. Riepe to highlight certain biases that lead to poor investment decisions including: overconfidence, optimism, hindsight and overreaction to past events, among them.
- Steve Pressman, an economist at Monmouth University, highlights overconfidence as “the primary psychological culprit” responsible for investors falling victim to frauds like Ponzi schemes.
- Medical doctor Ildiko Mohacsy and Heidi Lefer of the CUNY Research Council conclude from their studies that “investors often engage in wishful or magical thinking rather than logical thinking.”
- There is widespread financial illiteracy in the U.S. A study of Dutch investors finds that people with low financial literacy are less likely to invest in stocks than those who are literate. Few households in that study understood the difference between stocks and bonds, the inverse relationship between bond prices and interest rates or the concept of risk diversification.
- Both subjective and cultural factors determine how trusting people are and whether they are willing to invest and how much, according to research by Luigi Guiso of the European University Institute, Paola Sapienza of Northwestern University, and Luigi Zingales of the University of Chicago.
- Jonathan Skinner of Dartmouth finds “that those who save at high rates during their working lives are accustomed to consuming less and, therefore, do not need as much for retirement. Because they have set aside more, this pattern of saving more and consuming less provides investors with a double dividend.”
- Brad M. Barber and Terrance Odean, find in several papers that overconfidence — especially among men and online traders — correlates with active trading and that active traders underperform the market.
- Odean shows investors have a tendency to hold on to losing positions and sell winners, a reluctance to recognize loses.
- Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA find even long-term investors are unfortunately focused on short-term results.
- Expense ratios, transactions costs and load fees all harm mutual fund returns, but investors tend to disregard them, finds Mark M. Carhart, formerly of USC.
- James J. Choi, of Yale School of Management, David Laibson of Harvard’s Department of Economics, and Brigitte C. Madrian, of Harvard’s Kennedy School of Government, “report that investors disregard the costs of actively managed plans, focusing instead on annualized returns, which do not predict future performance.” Disclosure of management fees does not deter them, though investors with high financial literacy tend to pay low fees, in their findings.
- Multiple studies find we are bias to investing in companies that are near our home, including in our own country. Particularly dangerous: a bias to invest in our own employer’s stock.
- York University’s Brenda Spotton Visano describes financial mania as a “gradual spreading of speculative euphoria” where “optimistic uncertainty” becomes a “swell of speculative excitement” and eventually, when things go wrong, distress and panic.
- Other forms of investing where academics have found typical behaviors hurt long term results include momentum investing and investing in news-making stocks.
- Four researchers from the College of William and Mary and MIT find that women tend to invest more than men do in annuities, and they are motivated to that choice by emotions including trust, familiarity and loss aversion, leaving them to settle sometimes for more modest returns than necessary.
- K. C. Chan and Joseph Lakonishok of the University of Illinois Urbana-Champaign argue that value stocks often out-perform but “investors tend to underestimate the ability of value stocks to rebound and to overestimate the ability of glamour stocks to maintain above-average growth.”
- Meir Statman of Santa Clara Univeristy finds that the average investor holds only three or four stocks, though a properly diversified portfolio would hold closer to 300. Culprets include : concentration in employer’s stock, large-cap companies and domestic stocks.
The report concludes that the good news in all this, is that it gives us the opportunity to learn from the mistakes of others and not just keep on repeating the old mistakes.
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