50 Psychological Experiments for Investors

By Mickäel Mangot

Great book! Mickäel has done a great job of explaining the insights from over 50 groundbreaking psychological experiments. You will learn how to avoid many of the psychological mistakes made by most investors. He teaches you to watch out for overconfidence and the momentum bias to avoid large losses. He helps you to understand how your social relationships can change your asset allocation risk profile. Forearmed is forewarned. If you apply Mickäel’s insights, you will improve your investment performance.

Paul Stefansson
Executive Director, UBS AG

Why are investors sometimes their own worst enemies? As this eminently readable book shows, all sorts of biases affect investors’ judgments, ranging from sheer ignorance and emotions to overconfidence or aversions, from selected short-term memory to undue generalizations. Building on the expanding literature in behavioral economics, the experiments reported here shed a useful, often funny, light on the implicit rules investors use to form their judgment and decisions. This book will definitely help you make wiser investment decisions!

Christian Koenig
Director, Asian Center, ESSEC Business School

Mickäel Mangot provides a fantastic tool that individuals as well as financial advisors can immediately apply to their portfolios. This book’s success lies in its superbly easy-to-use format: Mangot demystifies the technical terminology of behavioral finance by linking everyday behavior to the world of investing. So while the human examples are enjoyable and interesting (you’ll chuckle when you recognize these traits in yourself), he deftly explains how these very human biases lie at the root of 57 simple but very damaging investment mistakes. Most importantly, each conclusion provides a concise, sensible summary to help you correct—and improve—your investment decisions.

Philippa Huckle
CEO, The Philippa Huckle Group

This is an insightful book that forces one to question one’s own financial behavior. 50 Psychological Experiments for Investors covers different topics such as savings, equity investment and property investment. The portrait of the investor presented here is harsh but can be highly profitable for anyone who recognizes that he or she is vulnerable to misjudgments and misguided emotions. A must-read for any self-questioning investor.

Jacques-Henri David
Vice Chairman Global Banking, Deutsche Bank

• Language: English
• Publisher: Wiley
• Release date: Nov 26, 2012
• ISBN: 9781118580349

Book preview

Preface

More than ever it is necessary to know how to save money. Economic and social upheavals demand a greater involvement of individuals in their financial decisions. Disparities in earned income continue to widen, forcing salaried employees to turn to other sources of income. The nature of remuneration itself changes with the expansion of stock options and company savings plans. The boom in real estate has again increased differences in wealth and created a gap between those who invested in brick and mortar and those who made another choice. In many countries, the pension system is switching inevitably from state-sponsored pay-as-you-go systems toward company-sponsored defined contribution plans and so the working population is going to be more and more in charge of its own retirement. The financial services industry, on the other hand, offers the individual saver an ever broadening assortment of products, increasing his chances of finding investments suitable for his needs, but making the choices less and less straightforward.

Yet, saving well is anything but an intuitive process. One must be capable of deciding how much to save each month and in what instruments to place those savings. These are the basic decisions which determine the wealth of the individual, household, or family in the long-term. Reactions, either instinctive or bred by personal experience or that of close acquaintances, do not always provide the golden rule for navigating the tricky waters of financial decisions. Arguments which seem to be a matter of common sense may in fact be folly. Emotions can lead to confused decisions or prevent wise choices. In the end, unconscious imitation and social comparison encourage the duplication of plans whose effectiveness is unknown.

But all is not necessarily lost. A confrontation of the opposing points of view of economics and psychology has given birth to a new area of research, behavioral economics, which elucidates how people in the real world make their economic decisions. This dynamic new discipline was endorsed by the awarding of the Nobel Prize in Economics to one of the discipline’s originators, Daniel Kahneman. Behavioral economics and its sister science of behavioral finance, created 15 years ago, continue to detail the differences between the economic and financial behavior of real individuals and what they should do if they were completely rational.

The story properly begins in the 1960s when Daniel Kahneman and Amos Tversky, psychologists at the Hebrew University of Jerusalem, were, at the request of the Israeli Air Force, thinking about the best method to motivate young pilots in training. At the time the instructors were railing against the popular wisdom, which maintained that encouragement gives better results than reprimand. They had noticed, in fact, that the pilots who were rebuked after a bad flight improved the next time, while students who received praise after a successful flight had a worse performance in the following flight. For them the connection was evident and so was the conclusion. In point of fact, they did not know (or had forgotten to apply) the basic statistical concept of regression toward the mean. When someone has a performance well below his average level, the probability that he will improve on the next try is very significant. Conversely, someone who has succeeded exceptionally well has a very good chance of doing less well the following time. That does not mean that the conclusion of the instructors was necessarily false; it would be necessary to conduct tests to make sure. What is certain is that the reasoning which led to this conclusion is faulty: the observed facts can be satisfactorily explained without invoking the idea of motivation. From that moment, the two researchers never ceased taking a keen interest in the heuristics of judgment, namely the unwritten rules which allow individuals to quickly form an opinion and make a decision. They studied them in Israel and then in the United States, where their efforts finally found the resonance they deserved, with Kahneman teaching at Princeton and Tversky, until his death in 1996, at Stanford.

From its beginnings, research in behavioral economics has operated largely through experiments conducted in the laboratory, most often on students. This method allows the experimenter to choose the environment in which decisions are made by the subjects and to control all the variables which can come into play and distort the conclusions. Other studies are done with real data (such as account statements) involving hundreds, if not thousands, of individuals. This approach has the merit of the analysis of real decisions, taken in situ, drawn from samples much larger than those in the laboratory experiments. On the other hand, it does not permit controlling the environment and so the conclusions can be more easily biased. A third type of study uses an intermediate methodology employing custom-made questionnaires in order to analyze the links between the decisions made by the individuals and their personal characteristics. Here the number of subjects is greater than the number of subjects in the experiments but the credibility of the data (self-administered responses) is less than that for real data; for example, the respondents may make a mistake or a deliberate falsification.

Whatever their nature, the impressive volume of studies on the behavior of investors draws a picture of the investor and his most hardened faults. In this book, a little over 50 experiments on different factors affecting investment decisions are presented. The most important questions are treated: portion of income allocated to savings, planning for retirement, choice between different investments, selection of mutual funds, attraction to real estate, hesitancy to invest in stocks, and so on. Mentioned too are anecdotal aspects of the problem, such as the Monday blues which take hold of the grumpy and overcautious side of the investor as he starts his week. These 50-odd experiments, in the end, allow a better understanding of our financial decisions. They offer information both for investing wisely and for knowing ourselves better.

CHAPTER 1

A Love of Anecdotes

How We Choose Information on Fallacious Criteria

SUMMARY

1. Why do you think you have to invest in the stock market when prices have skyrocketed?

Momentum bias

2. Why do you buy stocks when the market has gone up and bonds when the market has gone down?

Momentum management

3. Why are you sure that everyone agrees with your view that the market is going to go up?

False consensus

4. Why does Google’s success make you want to invest in high-tech?

The availability heuristic

5. Why has your stock portfolio only gained 5 percent this year when you are sure it has earned twice as much?

The confirmation bias

6. Why is it that on moving to the boonies you rent an overly expensive apartment?

Points of reference

1. Why do you think you have to invest in the stock market when prices have skyrocketed?

Momentum bias

Suppose—and the truth is not far off—that real estate prices had increased by 15 percent in 2004, 2005, and 2006. Do you think that the probability is high that they will post the same hike in 2007? Now suppose that the advance had been only 3 percent per year over the past three years. Is it still just as probable, in your opinion, that 2007 will finish with an increase of 15 percent?

Investors often think that what has occurred in the recent past can reoccur in the near future with a probability very much higher than is realistic. This behavior may originate in the failure to understand that when a random phenomenon is stable, it is necessary to observe it over a long period of time in order to obtain an accurate picture of its probability distribution. A practical consequence is that the tendency to give excessive weight to recent information distorts expectations regarding return on investments. It seems that individual investors are optimistic when the markets are bullish and pessimistic when they are bearish. De Bondt (1993)¹ used a weekly survey conducted by the American Association of Individual Investors (AAII) during the period from 1987 to1992 to assess the predictions of investors. The results demonstrate that their predictions for the movements in the Dow Jones index for the following six months are directly tied to the performance of the index during the week prior to the survey. The balance of opinion (optimist-pessimist) widens on average by 1.3 points for each percentage point the Dow gains during the week preceding the survey. More generally, the survey shows that the feelings of investors about the index depend on the market performance over the previous six months.

In the same vein, a study by the Gallup polling institute, ordered monthly by UBS PaineWebber, shows that the expectations of individual American investors over the years 1999–2002 followed the fall of the markets (see Table 1.1). As the American market was falling, the forecasts of the investors for the following year were being revised downward.

Table 1.1 Annual forecasts of American individual investors

Source: UBS PaineWebber/Gallup Survey of Optimism of Individual Investors.

Conclusion

Certainly the momentum bias arises as much from ignorance of the elementary laws of probability as from lack of information on historic returns. Increases of 15 percent in real estate prices or of 30 percent in the stock market are extreme phenomena that are much less probable than more modest changes conforming to historical averages. Betting on them is like betting on snow in Beijing in October. It is possible, but surely not very probable, even when July, August, and September have been quite cool.

2. Why do you buy stocks when the market has gone up and bonds when the market has gone down?

Momentum management

If momentum bias affects the expectations of investors, it also changes their management practices by encouraging investment based on the performance of investments in the short-term. The better the recent performance of investments considered risky, such as stocks, the more they attract investors. Similarly, when it comes to choices among different stocks, those which have gone up the most are most often put into portfolios.

Bange (2000)² has compared the results of the weekly survey by the AAII on the expectations of individual investors and those of the monthly survey by the same association on the distribution of assets (stocks/bonds/liquid assets). It too found that the predictions of individual investors were derived from past performances and that the weight of stocks in portfolios of investors increased accordingly. Thus the more markets go up, the more the individual investors are optimistic about future performance and consequently increase their exposure to stock markets. The more markets go down, the more investors are pessimistic and prefer to invest in bonds or to keep liquid assets.

In a study on the differences between investors based on the transactions of 41,006 clients of a large American brokerage house, Dhar and Kumar (2001)³ sought to classify individual investors into momentum investors (who believe in following the movements of the market) and contrarian investors (who believe in the correction of movements; see Table 1.2). They observed the behavior of stocks during the days and the months preceding the transactions that the investors made (buying or selling). They determined that on average the investors bought securities that posted significant gains over periods ranging from a week (+0.62 percent) to three months (+7.26 percent). Among the 41,006 clients followed, 12.6 percent systematically bought securities which had gone up over the past month (strictly momentum investors). The proportion of strictly contrarian investors was slightly less (10.4 percent).

Table 1.2 Recent performances of securities bought by individual investors (1991–1996)

Source: Dhar and Kumar (2001).

Conclusion

Ultimately, the more or less well motivated tendency to buy securities that have increased the most, turns out to be quite sound. The researchers identified a short-term momentum effect in many stock markets. Jegadeesh and Titman (1993)⁴ describe a momentum effect for American stocks for periods of three to 12 months during the years 1965–1989. For example, the best performers (winners) over nine months reported on average a return higher by 9.85 points in the nine months following than did the securities which had posted the worst performances. The momentum effect is more important for securities with extreme performances and for the small caps. It occurs as well on the European and some emerging markets.

3. Why are you sure that everyone agrees with your view that the market is going to go up?

False consensus

Momentum bias is the temporal manifestation of the bias of representativeness which encourages the individual to deduce the general rule from examples which are only anecdotes. False consensus is the social aspect of this bias. Numerous studies, beginning with those of Ross, Greene, and House (1977),⁵ have