Investors must learn a bit about bias
Insights into human psychology will help youto make more informed investment choices
NYSE traders: the positive behavioural reaction to a positive event is markedly less than the negative behavioural reaction to an equivalent negative event, hence markets tend to overreact. photograph: brendan mcdermid/reuters
The interest of economists, policy-makers and investors in the behavioural biases of the human mind has been intensifying in recent years.
Since the onset of the financial crisis, the striking failure of models which assume human rationality to adequately explain economic and financial market behaviour has given particular impetus to this interest.
The comforting assumption of rationality, which has guided influential figures such as former Federal Reserve chairman Alan Greenspan and many others in the academic, policy-making and investment world for decades, is increasingly being challenged by the behavioural insights of such as Daniel Kahneman, Nassim Taleb, Andrew Oswald and Dan Ariely.
Indeed, Greenspan himself has recently put pen to paper in a new book The Map and The Territory in which he attempts to grapple more fully with this challenge. In the introduction, in reference to the immediate aftermath of the Lehman collapse in 2008, he explicitly acknowledges the need for him (and others) to think anew: “The role of human nature in economic affairs was never more apparent than on that fateful day in September and in the weeks that followed … I began my post-crisis investigation, culminating in this book, in an effort to understand how we all got it so wrong, and what we can learn from the fact that we did.”
On this quest to better understand human behaviour, I believe the work of UCD professor of psychology Maureen Gaffney contains a timely behavioural insight for investors.
In her book, Flourishing, she explains how the human mind is continually registering positive and negative reactions to external and internal events. Each reaction triggers a cascade of changes in thinking and consequently in behaviour.
Prof Gaffney’s crucial insight is that the positive behavioural reaction to a positive event is markedly less than the negative behavioural reaction to an equivalent negative event.
Citing varied and compelling evidence, she quantifies this ratio as 3:1. In other words humans need to experience three positive events to cancel out the experience of an equivalent negative event. She goes on to say that this ratio tends to be 5:1 or greater in flourishing teams and organisations.
At a deep, fundamental level our survival instincts over the millenniums have hard-wired us to be much more attuned to the negative than the positive. The downside to running from an unknown rustle in the bushes, which might be a hungry lion but in the event is a harmless bird, is markedly less than the upside from staying put and being proven correct. Our overwhelming instinct is therefore to run.
Clearly, this finding has implications across many fields of human behaviour and interaction. Most relevantly for the investor, Nassim Taleb in his classic book, Fooled by Randomness outlines the following thought experiment which combines Gaffney’s with the scaling property of probability: “Let us manufacture a happily retired dentist, living in a pleasant, sunny town. We know a priori that he is an excellent investor and that he will be expected to earn a return of 15 per cent per annum with a 10 per cent error rate (volatility). A 15 per cent return with a 10 per cent volatility per annum translates into a 93 per cent probability of success in any given year.
“But seen at a narrow time scale, this translates into a mere 50.02 per cent probability of success over any given second as shown in the table [right].
“Over the very narrow timeframe, the observation will reveal close to nothing. Yet the dentist’s heart will not tell him that. Being emotional, he feels a pang with every loss. He feels some pleasure when the performance is positive, but not in equivalent amount as the pain experienced when the performance is negative.”
There are many lessons for investors in the insight of Gaffney combined with the retired dentist of Taleb, but I want to highlight just two:
1) There is nothing we can do about our differing behavioural response to negative versus equivalent positive news;
2) To improve our chance of investment success, we must try to defeat our instinct to assess the performance of our portfolio over short and irrelevant time periods.
In short, we may not be able to control our emotions, but we don’t have to let them dominate our investing.
John Looby is an investment manager at Setanta Asset Management, a global value manager based in Dublin. The views expressed are personal.