Jay D. Franklin

Cognitive Biases and Their Impact on Investment Decision-Making

Why is it that individual investors utterly fail to capture the returns of the market? For example, The DALBAR study shows an astonishing five point gap between the return received by the average equity investor and the S&P 500. Over the 20-year period studied, this return gap translates into a foregone gain of $173,000 after inflation (assuming that the investor started with $100,000 at the beginning of the period). Aside from the unnecessary costs paid by investors to brokers and active fund managers, the overwhelming explanation for the returns gap is simply bad behavior. Without delving deeply into the psychological or physiological underpinnings of what motivates poor investment choices (i.e., market-timing and performance-chasing), we will look at a couple of real-world examples of cognitive biases and relate them to investor behaviors that we at IFA have observed more than a few times.

Any fan of the TV show The Mentalist would appreciate the recent article in Wired magazine on the World Science Festival’s panel on Probability and Risk. The author recounts how Professor Josh Tennenbaum of MIT’s Department of Brain and Cognitive Sciences went up on stage and flipped a coin five times. He told the audience that he was going to concentrate on sending them a telepathic message containing the sequence of the coin flips and each person should write their guess of the sequence on an index card. By chance alone, about 3% of the audience should have gotten the correct sequence, but in this case, it was much higher and far too high to be explained by chance alone. Did Tenenbaum successfully give a demonstration of psychic abilities? There is little doubt that in a different venue, many in the audience would have been ready to accept this explanation.

The real explanation lends a great deal of insight into how our brains work: Essentially, we find it difficult to accept the fact that a sequence which appears not to be random (e.g., five consecutive heads) is just as likely as a sequence which has the appearance of randomness (e.g., HTTHH). Thus, the audience members limited themselves to choosing sequences such as the latter. As long as Tennenbaum’s sequence had an appearance of randomness, then he was guaranteed to match far more than 3% of the audience, but if he had flipped something like five consecutive heads, then he would have gotten the opposite result. Rather than attributing this phenomenon to a mental weakness, Tennenbaum suggested that our built-in sense of what makes for a random pattern confers a survival advantage to us over lower forms of life. In the realm of investing, however, the failure to rule out randomness (or luck) as the explanation for a few consecutive years of “benchmark-beating returns” can induce performance-chasing which is usually a costly mistake.

A second stage-based demonstration by Caltech physicist and author, Leonard Mlodinow, illustrates another cognitive bias that can lead to sub-par investment decision-making. Mlodinow split the audience in half and asked each half (working individually) to estimate the number of countries in Africa, but he added an interesting wrinkle. He asked the first group if they thought that there are more than five countries in Africa, and he asked the second group if they thought that there are more than 180 countries in Africa. Both of those numbers are, of course, way off the mark, so they should have had no impact on each person’s answer. Oddly enough, however, the “5” group came back with a much lower average number than the “180” group. The answers of both groups were affected by the meaningless numbers given to them at the beginning of the exercise. This is a beautiful example of the “anchoring” phenomenon where people latch onto a certain number (or concept) and order the world around them accordingly. In the realm of investing, we often see people who buy a stock based on a target price where they expect it to go in a relatively short period of time. This target price could be based on anything ranging from the latest Goldman Sachs analyst report to a number overheard in an elevator. These investors have anchored their expectations on what is most likely an unsound basis. If the stock goes down, they might reset their anchor to the original purchase price so that they do not have to realize a loss, thereby acknowledging that they made a bad decision but forgoing the potential tax benefit of a realized loss.

IFA does not advocate that investors try to eliminate their cognitive biases, as this is all but impossible. Rather, they should recognize them and be vigilant so that they are not led into poor decisions. This is where the services of a passive advisor can be most helpful. When acting as a behavioral coach, good passive advisors can prevent their clients from making common mistakes such as selling out at a market bottom or getting caught up in the latest investment craze (e.g., dot-com stocks in 1999). By simply assuring that investors receive their fair share of market returns, advisors provide a service whose value far exceeds its cost.