Investor Irrationality...
...is the reason for underperformance!
Historians who have examined the behavior of financial markets over time have challenged the assumption of rationality that underlies much of efficient market theory. They point to the frequency with speculative bubbles have formed in financial markers, as investors buy into fads or get-rich-quick schemes, and the crashes with these bubbles have ended, and suggest that there is nothing to prevent the recurrence of this phenomenon in today's financial markets. In fact, the evidence on price patterns, in the short and long term, in different calendar months and on different weekdays suggests that there is much about markets that we cannot explain with a rational investor model.
Psychological Studies
At the risk of stating the obvious, investors are human and it is not surprising that financial markets reflect human frailties. In an extraordinary book (at least for an academic economist), Robert Schiller presented some of the evidence accumulated of human behavior by psychologists that may help us understand financial market behavior. He categorizes these findings into several areas:
The Power of the Story
For better or worse, human actions tend to be based not on quantitative factors but on story telling. People tend to look for simple reasons for their decisions, and will often base their decision on whether these reasons exist. In a study of this phenomenon, Shafir, Simonson and Tversky gave subjects a choice on which parent they would choose for sole custody of a child. One parent was described as average in every aspect of behavior and standing whereas the other was described more completely with both positive (very close relationship with child, above-average income) and negative characteristics (health problems, travels a lot). Of the subjects studied, 64% picked the second. Another group of subjects was given the same choice but asked which one they would deny custody to. That group also picked the second parent. While the results seem inconsistent Ð the first group chose the second parent as the custodian and the second group rejected the same parent, given the same facts Ð they suggest that investors are more comfortable with investment decisions that can be justified with a strong story than one without.
Overconfidence and Intuitive Thinking
As you have undoubtedly become aware from your interactions with friends, relatives and even strangers over time, human beings tend to be opinionated about things they are not well informed on and to make decisions based upon these opinions. In an illustrative study, Fischhhof, Slovic and Lichtenstein asked people factual questions, and found that people gave an answer and consistently overestimated the probability that they are right. In fact, they were right only about 80% of the time that they thought they were. What are the sources of this overconfidence? One might just be evolutionary. The confidence, often in the face of poor odds, may have been what allowed us to survive and dominate as a species. The other may be more psychological. Human beings seem to have a propensity to hindsight bias, i.e., they observe what happens and act as it they knew it was coming all the time. Thus, you have investors that claim to have seen the crash in dot.com companies in the late 1990s coming during earlier years, thought nothing in their behavior suggests that they did.
Herd Behavior
The tendency of human beings to be swayed by crowds has been long documented and used by tyrants over time to impose their will on us. In a fascinating experiment, Asch illustrated this by putting a subject into a group of people, asking them a question to which the answer was obvious and then inducing other people in the group to provide the wrong answer deliberately. Asch noted that the subject changed his answer one-third of the time to reflect the incorrect answer given in the group. While Asch attributed this to peer pressure, subsequent studies found the same phenomenon even when the subject could not see or interact with others in the group. This would suggest that the desire to be part of the crowd is due to more than peer pressure.
While there is a tendency to describe herd behavior as irrational, it is worth noting that you can have the same phenomena occur in perfectly rational markets through a process called information cascade. Schiller provides an example with two restaurants, where people come into town one after another. Assume that the first person to come in picks the first restaurant and assume that the choice is random. The second person who comes into town will observe the first person sitting in the first restaurant, and is more likely to pick the same restaurant. As the number of subjects entering the market increases, you are likely to see the crowd at the first restaurant pick up, while business at the second restaurant will be minimal. Thus, a random choice by the first customer in the market creates enough momentum to make it the dominant restaurant. All to often, in investing, investors at early stages in the process (initial public offering) pile into specific initial public offerings and push their prices up. Other initial public offerings are ignored and languish at low prices. It is entirely possible that the first group of stocks will be overvalued, while the latter are undervalued. Since herd behavior is made worse by rumors by the spreading of rumors, you could argue that the coming together of the available data and media sites such as CNBC and MSNBC has made it more possible for herd behavior to spend and not less.
Unwillingness to admit mistakes
It may be human to err, but it is also human to claim not to err. In other words, we are much more willing to claim our successes than we are willing to face up to our failures. In an experiment on human behavior, it was noticed that subjects when presented with choices relative to the status quo often made choices based upon unrealistic expectations. They noted that a person who has not made peace with his losses is likely to accept gambles that would otherwise be unacceptable to him. Anyone who has visited a casino will attest to this finding.
In fairness, it should be noted that the evidence from other experimental studies is largely supportive of rationality. Investors do seem to make reasonable judgments based upon the information they have, and markets do a good job of aggregating this information in the market price.
