Why Smart People Do Dumb Things with Their Money

Posted by Alex Frey (@alexhfrey )

Like most people I think, everything that I can ever remember doing has seemed perfectly rational to me... at the second I was doing it. Reflecting years later... not so much. I won't go into details here, but you can use your imagination or look back at your own life and probably conclude something similar.

I have found investing is much the same way. Every investment I have ever made has seemed perfectly rational at the time. It is only years later, when it turns out that the CEO was fabricating the details of that new oil field and racking up short-term debt at the same time, that I realized that I might have been a bit too enamored with the story and did not ask some very basic questions. 

The difference between life and investing is that in life we tend to realize and acknowledge that (albeit some time in the distant past...) we may have at times made decisions based on something other than reason and logic, while with investing we usually just try to push the mistakes out of our minds and concentrate on the times when our superior reasoning abilities picked great investments (while not acknowledging the possibility that these might have just been luck...)

We would do well to understand how the same psychological forces that sometimes can lead to brash decisions in the rest of our lives can also apply to investing. This article looks at a collection of four: loss aversion, anchoring, overconfidence, and the endowment effect. 

Loss Aversion

In the world of textbooks, people make decisions between two financial options solely based on how their each might impact their final wealth. This is known as the "utility theory." In the real world, people tend to frame decisions as a "win" or a "loss" and tend to irrationally do whatever they can to avoid "losing."

For instance, imagine you are forced to accept one of two bets. In bet A, you have a 85% chance of losing $1000 and a 15% chance of losing nothing. In bet B, you face a sure loss of $800. What do you pick?

If you are operating according the laws of standard economics, you should choose bet B, the sure loss of $800. Why? Because bet A has an "expected outcome" of losing $850, since 85% of the time you will lose $1000. You can think of the expected outcome as the amount you would lose (per game) if you played the game hundreds of time. Imagine you play the game 1000 times. If you take bet A every time, you would lose about $850,000. If you take bet B every time, you would lose precisely $800,000. 

While bet B is clearly superior since it results in less average losses and also less risk, studies show that most people still will take bet A. Why? Because they want to avoid the feeling of "losing," and bet A is the only option that gives them the chance of coming out even. People will go to irrational lengths to avoid taking a loss. 

Paradoxically those same people will mostly favor an $800 sure gain over an 85% chance of winning $1000. So they are risk-seeking when it comes to losses and risk-avoiding when it comes to gains. 

While seemingly innocuous, our tendency to frame everything in terms of "wins" and "losses", and take irrational risks to avoid the "losses" has all kinds of (mostly disastrous) consequences. Studies have shown investors have a tendency to hang on to losing investments in the faint hopes that they will come back, and to prematurely sell winning investments in order to lock in gains, and that this can collectively cost them billions of dollars every year. 

Anchoring

In the world of traditional economics textbooks, people make decisions by carefully assessing all of the relevant information available, doing a cost-benefit analysis of each option, and choosing the one that comes out on top. In the real world, people are heavily influenced by the first piece of information that comes to their mind, even when that information has absolutely nothing to do with the matter at hand.

Anchoring has been cleverly shown by a now-famous experiment done by the psychologists Daniel Kahneman and Amos Tversky. The two researchers had participants observe a roulette wheel that was programmed to stop at either 10 or 65. The participants were then asked to guess how many African countries were members of the UN. Participants that saw the roulette wheel stop at the number 10 guessed there to be 25 African members of the UN, while those that saw the wheel stop at 65 guessed that there were 45 African members of the UN.

The random number that a roulette wheel stops at should not impact our view's towards African UN membership - but in the real world it does. 

Similarly in the investment world, our decisions on whether to buy or sell a stock are often subtly influenced by irrational factors like our experience using the product the last time, whether we are in a good mood or not, even what we ate for breakfast that morning. Of course at the time these factors are usually totally unknown to us, just as the participants in the roulette wheel performance all swore that the number the wheel stopped at did not have any impact on their resulting guess. 

Overconfidence

In the world of economics textbooks, people have a good idea of their own strengths and limitations. If citizens of your average economic textbook were given a quiz with questions like "How many surgeons are in the Boston phonebook" and asked them to estimate a range in which they are 90% sure the correct answer falls, you would expect them to get this "right" (within range) about 90% of the time.

In the real world, it turns out that people are remarkably overconfident of their own guesses and only get about half of their answers into what they claim is a 90% confidence interval. Somewhat amusingly, education and status seem to exacerbate this effect. Some groups of surgeons have (disturbingly) been found to be 98% sure about things they only get 50% right. 

Similarly, several now-famous studies show that people have a remarkably irrational self-reported view of their own abilities relative to those of their peers. A few highlights:

  • Some 93% of US drivers believe themselves to be in the top 50% of all drivers 
  • 25% of students believe they are in the top 1% of all students at getting along with others
  • 87% of Stanford MBA students are confident their academic performance is better than their average peer

The investment implications of overconfidence are pretty obvious: investors are likely to place far too much of an emphasis on their own understanding of the world, which can lead them to take on too many risks, not hold as diversified of a portfolio as they should, and trade far more than should be warranted. 

Endowment Effect

In the rational world of economics textbooks, whether you own something or not already should not have an impact on how valuable it is to you. For instance, to say that a 2001 Subaru Forrester has a $3000 value to you means that if you do not own a 2003 Forrester, you would be willing to pay $3000 for it, while if you do own it, you would be willing to sell it for about $3000. 

But in fact, if we do own the 2003 Subaru Forrester, have affectionately named it "Bubba," and have been through a couple of cross-country road trips with it, then we are probably not willing to sell it for $3000. Instead we might want $10,000. 

The attachments that people develop towards ideas and objects that they perceive themselves as "owning" is well documented in academic research, and it turns out that they do not even need years to develop. In one experiment, researchers found that students at Duke University were only willing to pay $166 for a ticket to a Final Four game in which the school's basketball team was playing. However, students that were then awarded a ticket in the lottery were unwilling to sell it for less than $2,411. 

We are Less Rational Than We Think

In conclusion, psychological research has proven that the "average" person makes decisions based on all kinds of factors that they were not even consciously aware of at the time. While it can be extremely difficult to "see" our own irrationality and frighteningly easy to see other people's, there is no reason to think that any of us are immune from these effects, as all of our brains evolved in the same kinds of environments. 

In the next article, we will look at how these subconscious biases from individuals can make their way into the broader market. 


Get our next article delivered to your inbox.

Sign up below and be the first to know about our freshest data-driven thinking on the markets, and investing. We will send you no more than one email a week. This is free.

Ready to start putting this into action?

Take a free two-week trial to IvyVest premium -- our premium subscription service. You'll get access to our rules-based dynamic asset allocation model, tools that will show you exactly what you need to buy in your own discount brokerage account (and when to re-balance) to implement it for yourself, and an insightful monthly newsletter that will keep you on abreast of the most important things going on in the markets. There is no credit card required. Get Started Now!


By Alex Frey