Published on September 3, 2021 in the Rochester Business Journal

In the investment world, and perhaps in life, there has always been a battle between the actions we should be taking and the actions we actually do take. It’s a battle between the impulsive part of our brain and the rational part of our brain and, unfortunately, the impulsive part of our brain often prevails. Human nature and our own innate biases work to our detriment in this regard and usually to the detriment of our portfolio returns. To understand why, we need to explore the foundations of neo-classical economic theory versus the principals of modern behavioral economics.

Neo-classical economic theory, made popular by Harry Markowitz in the late 1950s and early 1960s, suggests that investors have rational preferences, act with full information, and maximize utility (i.e. degree of happiness) in the actions they take. From these principles came the idea of Modern Portfolio Theory and the Capital Asset Pricing Model, suggesting that the return on any given asset should be the sum of some risk-free rate of return – like the rate of interest you can earn on a Treasury Bond - plus a premium influenced by how risky the individual asset being purchased is relative to the market, as well as the riskiness of the market itself. In short, prescriptive models like this attempt to explain what should happen in financial markets, based on logical and rational assumptions. The problem is investors aren’t always logical and rational, and the results predicted in these models are rarely what we observe, at least in the short run.

Contrary to neo-classical economic theory, the field of behavioral economics emerged to explore investor irrationality, with models that are predictive rather than prescriptive in nature. They identify heuristic characteristics and other human biases related to the impulsive part of our brain, and attempt to explain how we do behave, versus how we should behave. The empirical evidence from this field suggests that an untrained investor left to his or her own heuristic characteristics and natural biases tends to underperform a broadly diversified, equity-based investment portfolio by as much as seven percentage points per year.

One of the heuristic characteristics we all possess is an aversion to loss. In fact, the pain we feel from recognizing a loss has been shown to be far stronger than the happiness we experience from recognizing a gain; this can be problematic in portfolio management. Aversion to loss also lends itself to status quo bias (i.e. the tendency to do nothing), not because it’s in our best interest but because, in many instances, it’s easier to do nothing than to experience the pain of a loss.

Another heuristic characteristic we exhibit is placing a higher value on something we already own, versus something we don’t, even if the two items are identical. This is referred to as the endowment effect and it can also contribute to status quo bias. Think of a stock or a business that has been gifted or handed down. Some will refuse to part with the assets, despite the relative certainty of earning higher returns elsewhere, simply because of the attachment they feel to these assets. In the case of a privately-held business, there may also be an illusion of control, whereby an individual believes his or her business is safer than a market portfolio and that outsized returns can be earned under his or her direction, even though there’s never been any evidence to support these tenets. Refusing to let go of assets in this context can also work against your long-term investment returns.

A third heuristic characteristic we all possess is overconfidence. Despite the limits to the information we have access to or the extent we can reasonably process it, we tend to believe our own decisions are the best decisions and we look for affirmation in this regard. We tend to seek out reports that support our choices, leading to something known as confirmation bias, and we tend to point out times when our predictions were right in the past, even though they may have been one out of many; this is referred to as hindsight bias. Confirmation bias and hindsight bias lend themselves to subjective versus objective decision making, often to the detriment of our portfolio.

Many other natural biases have been identified, including home bias (i.e. the tendency to favor investments located in our own geographical region) and recency bias (i.e. the belief that an investment that outperformed last year will continue to outperform this year), not to mention other natural enemies to portfolio returns like fear and greed. Fear tends to prevent us from buying an asset when all the news of the day is bad, and greed tends to prevent us from selling an asset when all the news of the day is good, even though doing so might be exactly the right thing to do.

As we make investment-related decisions and look to optimize risk-adjusted returns to meet our needs, wants and wishes, it’s important to work with a trained financial professional who can help us overcome our natural biases and take the irrational part of our brain out of the equation. We should base investment decisions on the potential for return in the future and not what may have occurred in past. Removing bias and emotion from our decision making will undoubtedly improve risk-adjusted returns over time. Failure to recognize and overcome the natural tendencies identified in behavioral economics will adversely impact our investment returns and leave only ourselves to blame.

To see this column in the RBJ, click here.