The Educated Investor and the Psychology of Investing

Professor Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, Santa Clara, Calif.,

Taken from :
The Monitor, The Voice of the Investment Management Consultants Association,
May / June 2005: What is Behavioral Finance, The Monitor, 2005.Cognitive Biases Series: a collection of articles from IMCA's publication, The Monitor.

"I describe financial advisers as financial physicians. Good physicians promote both health and well-being, and good financial advisers promote both wealth and well-being. Good physicians ask, listen, and empathize with their patients; they diagnose what’s wrong; they educate; and, finally, they treat. Good physicians must possess all the relevant knowledge and tools of medicine, and they must also have the handholding and educational abilities of good psychologists. Good physicians must play psychologist because body and mind are not separate.

The same is true for financial advisers. Some financial advisers prefer to keep away from the wellbeing issues of their clients; they only want to find good money managers and calculate accurate alphas. I say to them what I would say to a physician who prefers not to deal with patients: be a pathologist.Confine yourself to a back room where you can choose money managers and evaluate their performance. Let someone else help live human investors."

So for all you "live, human investors"...many of you clients, some thinking about being clients and others perhaps looking for someone who really does care about you.......

In light of the current Investment environment, I have tried to find a good synopsis on Behavioral Finance theory, which can explain the thought process and research behind broadly diversified, less actively- managed portfolios. It is a bit long and a little technical, but I think it underscores what is important. The highlights (bold) are mine. I plan to build on this theme with a "webinar" ( a conference call seminar with live internet feed to your computer) shortly.

Psychology is the basis for human desires, goals, and motivations. Psychology is also the basis for a wide variety of human errors that stem from perceptual illusions, overconfidence, over-reliance on rules of thumb, and emotions.

Errors and bias cut across the entire financial landscape, affecting individual investors, institutional investors, analysts, strategists, brokers, portfolio managers, options traders, currency traders, futures traders, plan sponsors, financial executives, and financial commentators in the media.

Successful investing requires taking the psychological propensities of others into account.

Statistics and probability are essential concepts when it comes to risk. Yet, most people have poor intuition about statistics and probabilities. Instead of behaving like professional statisticians, they rely on flawed intuition, based on rules of thumb called heuristics. By using heuristics people render themselves vulnerable to errors and biases. That is why the first theme of behavioral finance is called heuristic-driven bias.

A frame is a description. Frame dependence means that people make decisions that are influenced by the manner in which the information is presented. Frame dependence manifests itself in the way that people form attitudes towards gains and losses. Many people make one decision if a problem is framed in terms of losses, but behave differently if the same problem is framed in terms of gains. An important reason for this behavior is loss aversion. Hedonic editing is the practice of choosing frames that are attractive relative to other frames. People with self-control problems often use hedonic editing to help them deal with those problems.

Markets are efficient when prices coincide with intrinsic value. Heuristic-driven bias and frame dependence combine to render markets inefficient. Representativeness leads to the winner–loser effect, whereby investor overreaction causes prior long-term winners to become future long-term losers, and prior long-term losers to become future short-term winners. Conservatism leads security analysts to underreact to earnings surprises, thereby generating short-term momentum in stock prices. Frame dependence leads investors to frame stock returns in terms of short horizons instead of long horizons. As a result, investors require a larger equity premium than they would if they framed returns using longer horizons. Prices can deviate from fundamental value for long periods, with excess volatility the result.

Wall Street strategists are susceptible to gambler's fallacy. In general, four important behavioral elements affect the market predictions of investors: overconfidence, betting on trends, anchoring and adjustment, and salience. Although gambler's fallacy generally afflicts Wall Street strategists, it typically does not afflict individual investors and technical analysts—they succumb to other errors. This point leads to a discussion about some of the key illusions that most people have about randomness, and why these illusions bias their predictions. Inflation adds an additional element of confusion.

Many investors believe they can make money by betting against the market predictions contained in advisory newsletters. Yet, they are wrong. Investors are wrong about advisory newsletters, and they hold fast to mistaken beliefs. And the issue goes beyond the predictions of newsletter writers. The general question is why people hold views that fly in the face of empirical evidence. The general explanation centers on overconfidence, overconfidence that stems from the tendency to overlook disconfirming evidence. Consequently, overconfident investors come to hold invalid beliefs. They succumb to what psychologists Robin Hogarth and the late Hillel Einhorn call the illusion of validity.


The third theme of behavioral finance is inefficient markets. In recent years scholars have produced considerable evidence that heuristic-driven bias and frame dependence cause markets to be inefficient. Scholars use the term “anomalies” to describe specific market inefficiencies. For this reason, Eugene Fama characterizes behavioral finance as “anomalies dredging.” Market efficiency is a direct challenge to active money managers, because it implies that trying to beat the market is a waste of time. Why? Because no security is mispriced in an efficient market, at least relative to information that is publicly available. Inside information may be another story.

Placing funds with an active money manager is typically a bad bet. Yet, institutions continue to hire active money managers. Why? The short answer is that the individuals who serve on institutional investment committees exhibit frame dependence and heuristic-driven bias. When it comes to framing, committee members tend to think of portfolios as a series of mental accounts, with associated reference points known as benchmarks. Therefore, they tend to mistake variety in manager “styles” for true diversification. In addition, reference point thinking tends to make people give opportunity costs less weight than out-of-pocket costs of the same magnitude. In addition to frame dependence, members of institutional investment committees bear responsibility for the performance of the portfolio. Consequently, they are vulnerable to regret. Choosing active managers enables committee members to shift some of the responsibility for performance onto the managers, thereby reducing their own exposure to regret. Heuristic-driven bias stems mostly from reliance on representativeness. Specifically, representativeness underlies the mistaken belief in a “hot hand,” an effect that leads sponsors to believe, mistakenly, that they have the ability to pick managers who can beat the market.

Abstracts from:
Beyond Greed and Fear
Understanding Behavioral Finance and the Psychology of Investing

Shefrin, Hersh Holds the Mario L. Belotti Chair in Finance, Leavey School of Business, Santa Clara University
Print publication date: 2002 (this edition)Published to Oxford Scholarship Online: November 2003Print ISBN-13: 978-0-19-516121-2doi:10.1093/0195161211.003.0006

If you made it through and want to discuss this further, feel free to contact me.

Next blog I'll devote to Private Equity financing and specifically, Jacoline Loewen's new book Money Magnet - Attract Investors to Your Business http://canadianprivateequity.blogspot.com/.....so stay tuned!!