Irrational Investing - Behavioral Finance understood under Adaptive Markets Hypothesis

An Interesting Commentary on How Investment Decisions Are Made
The following is a reprint of an article that goes into some detail on how investment decisions are made. It seems appropriate today. It is a bit long and a bit wordy, but investors should always be better investors if they understand what prompts their own investment decisions.

The following piece makes one think about how their own investment decisions are made, and if you as an investor understand why you choose one investment over another, your decisions can be vastly improved. I urge you to take the time to read this.

Financial Post – David Pett Apr 27, 2012
In the late 1960s, when Arnold S. Wood was an equity analyst trainee at a large bank in Boston, he walked into an investment committee meeting one day with a recommendation to buy Ford Motor Co. shares. After finishing his presentation, the head of the committee thanked Mr. Wood for his thorough analysis, but said he would not be taking the advice. The reason: His wife recently bought a Ford that was nothing but trouble.

Mr. Wood couldn’t believe his ears. At the time it was widely accepted that investors act rationally when making decisions and, based on his research, Ford’s lemon rate was one of the best in the industry.

“I had done all this work and it put a prick in my balloon,” said Mr. Wood, recalling the incident. “I thought: This is not the way you should make investment decisions.”

But Mr. Wood, now the CEO of Martingale Asset Management and trustee of the research foundation of CFA Institute, has learned all too often over the ensuing years that investors are easily misguided by their irrational biases, beliefs and preferences.

It’s a conclusion shared by many other market participants. As a result, retail investors, financial advisors and professional money managers are increasingly employing the tenets of a different investing practice called behavioral finance as a way to better inform their decision-making.

“There is a growing realization that people are not entirely rational and that emotions play a key role in how markets function,” Mr. Wood said.
The long-held wisdom that markets are efficient and investors are rational was first introduced when modern portfolio theory was developed in the 1950s. The theory was that portfolio returns could be maximized without additional risk through owning a diversified basket of stocks and bonds.

The efficient markets hypothesis then emerged in the 1960s, stating that security prices at any given time fully reflect all available information, making it impossible for investors to do better than the overall market. While these traditional investment paradigms have become the cornerstone of standard financial planning practices, they have not been immune to criticism over the years. They have come under particularly heavy scrutiny from all corners of the investment community since the financial crisis of 2008.

“[They] seem woefully inadequate,” said Andrew Lo, a professor at the MIT Sloan School of Management in an article published in the Financial Analysts Journal. “But simply acknowledging that investor behavior may be irrational is cold comfort to individuals who must decide how to allocate their assets among increasingly erratic and uncertain investment alternatives.”

In order to reconcile behavioral biases with basic finance principles, the adaptive markets hypothesis has emerged as an alternative. The theory recognizes that investment decisions are made using logical reasoning, but also physiological mechanisms — such as the fight-or-flight response — that are inherent in all animal species and that can result in highly disruptive behavior.

‘There is a growing realization that people are not entirely rational and that emotions play a key role in how markets function’
“When being chased by a tiger, it is more advantageous to be frightened into scrambling up a tree than to be able to solve differential equations,” Mr. Lo said. “From a financial decision-making perspective, however, this reaction can be highly counterproductive.”

Complicating matters is that investment decisions are impacted by the psychology of groups as well as an individual’s psychology, Mr. Wood said. Adding this group dynamic can make investors even more or less confident than is otherwise warranted.

For instance, they may create unwarranted expectations for themselves by selecting data or opinions from so-called experts not because they are right, but because they support investors’ own previously held convictions. On the other hand, they might also see patterns in random occurrences, which further skews their confidence.

Investors also assume the more information they have, the better decisions they will make. But people have limited, selective memory and storage capacity, something that in psychological circles is known as bounded rationality. Put simply, the ability to process information and calculate its utility is lost beyond a certain point, a point that is different for each person, Mr. Wood said.

By recognizing these behavioral shortcomings, behavioral investing theorists believe investors can develop more effective ways to allocate assets and manage their investments.

For instance, it has never traditionally paid to engage in “tactical shifts,” Mr. Lo said, because timing the market was thought to be virtually impossible and therefore an ineffective strategy. But the adaptive markets hypothesis implies that investment policies must be formulated with the knowledge that market efficiency is not an all-or-nothing condition, but a continuum. During periods of extreme fear or greed, traditional approaches to asset allocation and diversification may no longer be effective because they may not provide adequate rewards for the risks taken.

“Diversifying one’s investments across 500 individual securities — for instance, the stocks of the S&P 500 Index — used to be sufficient to produce relatively stable and attractive returns over extended periods of time,” he said. “However, in today’s environment, these 500 securities are so tightly coupled in their behavior that they offer much lower diversification benefits than in the past.”

For his part, Mr. Wood thinks investors’ success — or failure — is not based on their ability or skill, but on the choices they ultimately make. The best way for investors to improve performance, therefore, is to acknowledge any behavioral shortcomings, such as undue worrying or excessive optimism that undermines their ability to make rational financial decisions, and work to narrow the “emotional pendulum” related to market swings.

“If people find themselves warming to a particular investment idea, they should ask the question, ‘What can go wrong here?’” he said. “People need to sleep on their ideas a little bit, just to make sure they are not being fooled by themselves.”

Investors might miss the start of a true rally or downturn, but they likely won’t get burned in the long run from making a hasty decision

Examine Your Own Thought Process
The foregoing is highly logical and well thought out. While it is written from an educational and research point of view, it does point out how most of our every day investment decisions are made. Making a short checklist that you must answer or “tick off” before actually making an investment, might force the investor to apply a logical and rational decision-making process to an investment decision. The checklist would be easy to create and would involve asking 3 or 4 ‘yes’ or ‘no’ questions taken from the above article.

Good investing.

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