Human Misjudgments, Biases, and Emotions in an Investment world

 

As Benjamin Graham once quoted – “While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”

Time and again we have seen in history of stock markets that irrational exuberance has caused disasters. Be it during the internet bubble of 2001 or economic Pearl Harbor of 2008, human misjudgments, biases, and emotions have led to economic catastrophes. Behavioral finance is one of the most misunderstood and neglected field in an investment world. It combines behavioral and cognitive psychological theory with conventional finance to provide better explanations to – why people behave irrationally. Behavioral finance appeared on my radar screen when I came across Charlie Munger’s famous speech on “24 Standard Causes of Human Misjudgment” on YouTube. These causes of human misjudgments can have powerful implications while making any kind of an investment decision. I would like to run you through few of the most important lessons that we could possibly learn from this speech. Hopefully sooner or later it might help us make a better investor. Let’s take a look at some of the biases that might influence an investors’ decision.

Reward and Punishment Super response Tendency

As mentioned by Mr. Munger in this lecture – “We know incentives and disincentives play a huge role in changing our cognition and behavior. One of the most important consequences of incentive superpower is what I call incentive caused bias”.

As seen during the global financial crisis of 2008, quite a few bankers sold low quality assets to their clients, even when they knew those assets were going to be worthless sooner or later. Mortgage lenders had incentive to relax the underwriting standards so as to gain market share, investment bankers had incentive to sell mortgage related financial products to their clients so as to get more commissions, hedge fund managers had incentive to buy those products for their clients so as to show more investment returns, while credit rating agencies had incentives to misprice the risk related to those products so as to retain their clients. At the end, it were the investors, who suffered because of this incentivizing cycle. Charlie Munger mentions that it is of utmost importance to double check, disbelieve, or replace much of what we are told, to the degree that seems appropriate after objective thought.

One such recent example of effect of incentives can be seen from the Netflix (NFLX) chart. Stock was at its peak on Oct 2nd 2013 at around $330. NFLX was approaching its end of Q3 2013. Many of the portfolio managers, who had substantial positions in NFLX at that time, tried to book their profits causing stock price to dip to $288. As it is clear that cashing in at the end of quarter high is way to ensure the profitability. Majority of the portfolio managers take their profits on quarterly basis. Hence as an investor one should be careful of such market behavior before deciding to buy or sell an asset.

                                            Fig 1:  NFLX stock price movement near end of Q3 2013. (Source: Google Finance)

Fig 1:  NFLX stock price movement near end of Q3 2013. (Source: Google Finance)

Simple Pain-Avoiding Psychological Denial

A woman who lost his son in the battle field, denies to accept the death of her son. She is in simple pain-avoiding psychological denial. As per Munger, if reality is too painful to bear, humans distorts the facts until they become bearable. These distortions can be killer in an investment world.  Let’s take an example of Microsoft (MSFT) under the leadership of Steve Ballmer, to show how psychological denial can destroy shareholder’s value.

Fig 2: MSFT stock price movement since Jan 2000. (Source: Wall Street Journal)

Fig 2: MSFT stock price movement since Jan 2000. (Source: Wall Street Journal)

Under his leadership, Microsoft have had total negative return of nearly 17.6% and stock prices have fallen 36%, according to data from FactSet. Microsoft has spent billions of dollars on research and development to produce new technologies and products in the last 10 years. However, this has not clearly reflected on shareholder’s equity value. An investment of $1,000 in January 2000 would now be worth just $767 after reinvesting dividends, according to data from FactSet. The same investment in Apple would be worth $20,120.

Steve Ballmer helped build one of the greatest companies of the 20th century. However, he was in typical psychological denial mode to accept the growth of smart phones and tablet market. He even once made fun of iPhone, claiming that no one would pay $500 bucks for a phone.  He distorted the fact that the next wave of future innovations would come from mobile and tablet industry. Time and again we have seen in an investment world, where investors are in psychological denial phase to accept the fact that they have made bad investment choice.

Consistency and Commitment tendency

Munger states that: “The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in.” In other words, once people make a decision (to buy or short a stock, for example), then it becomes extremely unlikely that they will reverse this decision, especially if they have publicly committed to it. Billionaire hedge fund manager, Bill Ackman conducted a high-profile short promotion against Herbalife in December 2012. He eventually ended up losing $400 – $500 million in Herbalife shorts.

Fig 3: HLF stock price movement since December 2012. (Source: Google Finance)

Fig 3: HLF stock price movement since December 2012. (Source: Google Finance)

Ackman claimed that Herbalife (HLF) was an “illegal pyramid scheme”, and publicly committed about his short positions in HLF in December 2012. He kept arguing that HLF was a fraud and that it eventually would go bankrupt. Stock price of HLF has moved up by 130% since he made his first presentation on HLF. This is a perfect example of commitment bias. It leads to people shutting out new ideas/actions that contradict their earlier conclusions or commitments.

Certainly avoiding these biases can be difficult for many people. However, if we develop a habit of looking at objective evidences while making any decision, we can possibly avoid making mistakes. Another way to avoid these biases is to open up the boundaries and think as broadly as possible. Applying inter-disciplinary approach in your thinking can help you become a better decision maker. As Charlie Munger had once quoted “We have a high moral responsibility to be rational”.

References:

  1. http://law.indiana.edu/instruction/profession/doc/16_1.pdf
Akhil Parekh is a Research Associate for the Rotman Asset Management Association. He will be graduating from the MBA program at the Rotman School of Management in 2015. Akhil can be reached at Akhil.Parekh15@rotman.utoronto.ca
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