The ‘psychology of stupidity’ in decisions on investments

Psychologist Daniel Kahneman's insights into dodgy decision-making and human irrationality helped revolutionise economic thinking, replacing the idea of the selfish, rational investor with something altogether more human and emotional. Once a fringe field, behavioural economics is now firmly in the mainstream, but some, like the philosopher who told Kahneman he was "not really interested in the psychology of stupidity" remain sceptical.

Are behavioural failings limited to the less bright, or are all of us prone to cognitive misadventures? Answer the questions below and see for yourself.

Quiz

(1) You are offered a certain gain of €3,000. Alternatively, you can choose an 80 per cent chance of winning €4,000, and a 20 per cent chance of receiving nothing. Choose.

Another question. Would you choose a certain loss of €3,000, or an 80 per cent chance of losing €4,000, and a 20 per cent chance of losing nothing?

(2) Is your driving above average, average or below average?

(3) Your friend notices that your lottery ticket contains her birth date and offers to trade her ticket for yours. Would you exchange it?

(4) Think of the last four digits of your phone number. Is the number of doctors in Dublin higher or lower than this number? What is your best guess as to the number of doctors in Dublin?

The ‘answers ’

(1) Studies show almost all people choose the certain gain of €3,000, despite excellent odds of gaining €4,000. This caution is abandoned when it comes to the question of accepting a €3,000 loss, however, most people preferring to gamble even though it is likely to result in an even bigger loss.

We hate losses – it’s estimated the pain of a euro lost is at least twice as great as the joy of a euro gained. This instinctive loss aversion, as behavioural economists call it, results in cautious investors embracing bad gambles to try and avoid losses. Many an investor has lived to regret uttering the words, “I’ll get out when I’m even”.

How ingrained is loss aversion? Very – golfers make better putts when trying to save par compared to when they try to make a birdie; lab studies show monkeys work much harder to avoid losses than to make gains; brain scans show the fear of losing money is like the fear of physical pain.

(2) Think you’re an above-average driver? Everyone does – one study found 93 per cent of US drivers believed they were better than average.

A second study found that, of more than 2,000 people given a 10-question quiz and asked to state how confident they were in their answers, fewer than 1 per cent were not overconfident. Another asked doctors to make a diagnosis based on patient case studies – when they were 90 per cent sure they were right, their diagnosis turned out to be accurate less than 15 per cent of the time.

Some 68 per cent of analysts believe they are above average at forecasting earnings, while, at the peak of the technology bubble, nearly 90 per cent of technology company chief financial officers thought their stock was undervalued.

Market analyst and behavioural finance author James Montier notes experts are even more overconfident than lay people, with people becoming much more overconfident when they are presented with extra information – even when that information is of limited use.

When an investment fails, we curse our bad luck. When it’s a winner, we attribute it to skill. Behavioural finance expert Terrance Odeon’s studies found that overconfidence is the main reason for overtrading, concluding: “People think they know more than they do, and it costs them.”

Overconfidence, one could argue, is at the very heart of the fund industry. Managers invariably charge high fees as they try – and fail – to beat the market. “Investment bankers believe in what they do,” Kahneman once said. “They don’t want to hear that their decisions are no better than chance. The rest of us pay for their delusions.”

(3) Most people tell their friends to get lost and refuse to exchange their lottery tickets, due to the fear of regret, that inner voice whispering “what if I give away the winning ticket?”

Regret may be as important as greed in the development of market bubbles, pained investors who missed out on earlier gains eventually joining the herd and driving prices to crazed levels.

When the bubble bursts, the same fear (“what if I sell just before the market rebounds?”) causes many to stick with their collapsing stocks.

(4) Readers know there is zero connection between phone numbers and the number of doctors in Dublin. However, James Montier found people whose last four digits are greater than 7000, on average, report 6,762 doctors; those with phone numbers below 2000 arrive at an average of 2,270 doctors.

Montier’s idea was inspired by a bizarre but brilliant study by Kahneman. Kahneman asked people to spin a wheel of fortune, write down the number on which the wheel stopped (the wheel was rigged, and would always stop at either 10 or 65), and then guess the percentage of African nations in the UN. The average estimate of those who saw 10 and 65 were 25 per cent and 45 per cent respectively.

It’s called anchoring. “In the face of uncertainty we will cling to any irrelevant number as support,” says Montier, who cites countless studies showing how analyst forecasts, price targets, economists’ GDP predictions and so on are of no use whatsoever to investors. “So it is little wonder that investors cling to forecasts, despite their uselessness.”

Investors may also anchor to the price at which they bought their stock (which is of no relevance to anyone but themselves) and a stock’s previous high.

A stock may appear cheap to an investor who watches it plummet from €10 to €5. However, it may well be overpriced – the price decline may reflect changing fundamentals or the ongoing deflation of a bubble-like valuation.

Like all behavioural quirks, anchoring can be seen in every area of life. One study asked judges to roll a dice, and then specify the prison sentence they would give a shoplifter. Those who rolled a nine said they would issue an eight-month sentence; those who rolled a three suggested a five-month sentence.

Lessons
The above examples show we are all inherently prone to behavioural failings. "I never felt I was studying the stupidity of mankind in the third person," Kahneman once admitted. "I always felt I was studying my own mistakes."

What can we do about our biases? Not a lot, Kahneman writes in his 2011 bestseller Thinking, Fast and Slow "without a considerable investment of effort". His intuitive thinking is "just as prone to overconfidence, extreme predictions, and the planning fallacy" – the habit of underestimating how long it will take to finish a task – "as it was before I made a study of these issues". Despite a lifetime of research, he has "made much more progress in recognizing the errors of others than my own".

That sentiment, alas, is one all too many of us will relate to.