Avoiding Irrational Investing

Marques Nielson |

A great deal of financial advisor’s time is spent keeping their clients from making financial decisions that are not in their best interest.  Why is this?  What causes otherwise intelligent individuals to make poor investment decisions?  This newsletter explores human nature, behavioral finance, and why our gut instincts aren’t always rational when it comes to investing.  To begin, I will introduce a giant in the field, Daniel Kahneman.  He won the Nobel prize in economics, although he was primarily a psychologist.  This alone gives us a hint towards answering our question.  Kahneman and Amos Tversky, his co-author, showed that inherent biases often cause investors to deviate from rational behavior.  Their work launched the field of behavioral finance, which outlines these biases and highlights the traps into which investors can fall.  Although it seems a vast oversimplification to distill their work into a single newsletter, I will try to present a bite-size portion for you here:

People are Overconfident

A portion of Kahneman’s work focuses on trading volume.  To put it simply, there is too much of it.  A rational investor should trade only in certain circumstances: when money is deposited or withdrawn, for tax management, or when new information becomes available.  It seems that we receive a steady stream of new information every day, but even that doesn’t account for trading volumes that occur.  The main reason for this is overconfidence. 

A person's hand reaching for a crocodile

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Overconfidence does not always lead to favorable results.

People tend to construct narratives to understand the world.  The same is true for investors trying to understand the market.  Retail investors tend to be overconfident in the stories they tell themselves about companies and their potential for greatness or decline.  They sell some stocks and buy others, because they are convinced that the latter will outperform the former.  However, many studies show that retail investors trade on too many ideas, and are wrong on average.  Over a one-year time horizon, the average return on the all the stocks bought by retail investors is 3.3% lower than the stocks sold; and when looking at the stocks bought shortly after a sale, those purchased underperform those sold by 5.82% after one year.[1]  As you can imagine, this kind of batting average can significantly impact portfolio performance over the course of one’s investing lifetime.  To avoid this trap, we must recognize that holding for the long term often serves us better than trading based on the latest news story. 

Framing and the Power of Losses

Kahneman also showed that people tend to focus more on short term gains and losses than long term wealth.  This “narrow framing” distracts investors from a full portfolio view by causing them to focus on individual positions.  This is in part because investors, and humans in general, are more upset with losses than we are pleased with gains of the same size.  This is somewhat unsurprising if you think about it from the standpoint of our ancestors – it was certainly more costly to be killed by a wooly mammoth than it was rewarding to successfully hunt and eat one yourself – so the tendency to dislike losses more than we appreciate gains is somewhat baked in. 

Note the two boxes below, taken from Kahneman’s Nobel lecture:

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The inner square on the left appears brighter than the inner square on the right, but in reality, the two inner gray squares are identical.  In simplistic terms, this can be explained by saying that your mind’s perceptions are impacted by the information it receives.  In this instance, the eyes detect a change of state between the grey squares and your mind constructs the mental representation that we “see”.  Decision making follows a similar mental process.  In investing, the change of state is often expressed as a gain or a loss.  What we perceive directly affects decisions we make.  This phenomenon is generally referred to as “framing”.

Similarly, retail investors are more likely to sell stocks that are up relative to cost basis, rather than down.  This is because selling a stock while it is in the green makes an investor feel that they have succeeded, while selling stocks down relative to cost basis makes them feel that they have failed.  Although we have all heard to “buy low and sell high” this is not an optimal investing strategy by itself.  Investors should not only sell based on a stock’s price relative to its cost basis, but also on the stock’s potential going forward.  To make matters worse, investors also tend to extrapolate from anecdotes and personal experience to validate their judgments of a stock, an industry, or a company.  These extrapolations are often erroneous and unlikely to match actual data.  To sidestep these pitfalls, we must strive to keep our overall investment strategy in mind when making investment decisions. 

Our Minds Seek Coherence

More broadly, Kahneman demonstrated that we often attempt to create an understanding of uncertain situations through hindsight.  We all face uncertainties in our everyday lives and often struggle to make rational decisions when we don’t have all the facts.  One response to this unavoidable uncertainty is to create an understanding of a situation in retrospect.  Investors will often inadvertently claim greater understanding of a situation in retrospect than was actually the case.  As Kahneman noted in an interview with the BBC, “Many people predicted the Great Recession. Many more now, than then.” 

Take a close look at the picture below while squinting your eyes slightly

A group of girls standing outside

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If you see a face that isn’t actually there, this is your mind attempting to create coherence from a blurred image. 

This is known as “hindsight bias” and it can lead to an exaggeration of the coherence and predictability of the world.  When investing, this can lead us to think that we ought to be able to determine which stocks will do better than others.  This skews an investor’s judgment, leads to unfounded levels of conviction, and ultimately reduces diversification within a portfolio.  For these reasons, it is important to stick to an investment strategy rather than trying to time the market or predict winners. 

We are all human (well most of us), and biases are an inescapable part of human nature.  The investment decisions of untrained retail investors are often swayed by these biases and their overall performance suffers because of them.  Conversely, professional investors and financial advisors strive to develop a strategic investment plan for clients rather than making one-off, short-term decisions.  This approach helps to counter the very human biases that Kahneman, Tversky, and the behavioral economists who followed in their footsteps, revealed. 


[1] Odean, Terrance, 1999, “Do Investors Trade Too Much?” American Economic Review, 89(5): 1279-1298. Other studies showed similar effects of excessive trading. 

These are the opinions of Retirement Strategy Group and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal."