An Introduction to Behavioral Economics:
A Tale of Two Systems
A recent study from Morningstar, Inc. compared the performance of a wide variety of
mutual funds over the past 10 years to the performance actually realized by the funds’
investors. The funds returned an average of 7.1% a year, but the investors realized a return of
only 6.1% a year, leaving 1.0% per year of return on the table. On an investment of $100,000,
that’s almost $18,000 of forgone gains over 10 years. The bad news is that the difference in
performance was caused by the investors buying high and selling low as their emotions were
whipsawed by a seemingly unending stream of highly-charged headlines (Dow 6,547.05,
anyone?). The good news is that investors can avoid being unduly swayed by emotion if
they learn how the mind can trick us into making sub-optimal financial decisions.
In the past, most experts viewed the typical investor as belonging to the species of “homo
economicus” or, in other words, someone who always acts completely logical and rational
when it comes to making financial decisions. To the contrary, over the last 40 years, several
researchers including Richard Thaler, Daniel Kahneman, and Amos Tversky have proven
that humans do not always make rational economic decisions.
We tend to make decisions in two ways, almost as if our minds have two different operating
systems. Daniel Kahneman calls these two systems “System 1” and “System 2.” When we
use System 1, we make decisions quickly based on instinct, intuition, and “gut feel.” We use
past experience, habits, and mental shortcuts called heuristics. Sometimes our minds engage
System 1 without conscious thought on our part. Recent research has shown that when we
operate on the basis of habit, the part of the brain that controls conscious thought and
reasoning (the prefrontal cortex) virtually shuts down and we operate on auto-pilot. System
1 works well for basic situations that are similar to past situations, but System 1 can lead to
faulty decisions when the present is not like the past. System 2 is based on conscious,
directed thought. System 2 is supposed to take over from System 1 in appropriate
circumstances such as novel situations, but it is often blindsided by System 1’s shortcuts. In
order to make the best financial decisions, it is important to understand the types of errors
that System 1 generates.
When it comes to making financial decisions, System 1 presents us with three key biases.
Anchoring: When we attempt to answer a question in the face of uncertainty, we are
influenced (or anchored) by numbers that we have seen in the past. Uncertainty is created
by the need to project future outcomes (such as investment returns or retirement expenses), a
lack of information about an issue (such as whether an asset class is overvalued), or a novel
experience (such as an unprecedented geopolitical event).
Even experts can fall into this trap. One group of researchers asked 52 legal experts to
participate in a study involving criminal sentencing. The participants were asked to assume
the role of a judge evaluating a prosecutor’s sentencing recommendation. The participants
first rolled a set of dice to determine the prosecutor’s recommended sentence (i.e., the
anchor), and then were asked to complete a sentencing questionnaire in order to come up
with their own independent recommendation. The researchers found that participants who
faced a higher sentencing recommendation from the prosecutor tended to assign higher
sentences themselves, even though they knew the prosecutor’s recommendation was
completely random.
In the financial world, we saw significant evidence of the anchoring effect during the dot
com bust. Some investors pegged the fair market value of their internet investments based
on the maximum value that those investments reached in late 1999 and early 2000 (“the highwater mark”), even though every other data point other than the high-water mark indicated
that those values were not supportable. As the values started to decline, many investors
refused to sell for less than “fair market value,” even though they still would have realized a
significant gain at the lower price.
The best way to avoid the anchoring bias is to review the value of your investments based on
all of the available data rather than just one or two data points. It is especially important to
consider data that contradicts what your mind may consider “key data.”
Availability Bias: People tend to weight their decisions more strongly towards more recent
information, which causes the latest news to have the greatest impact. In other words,
investors overreact to the headlines. When an investor hears about a hot stock, System 1 can
take over and put the stock’s short-term performance ahead of other data points that the
investor may have considered in the past, such as the price/earnings ratio, the competitive
landscape, and the company’s management team. The same holds true for the stock market
as a whole. When the market seems to hit a new historical high every day, System 1 tells us
that we’re missing out on a good opportunity, when in fact some sectors of the market may
be overvalued.
In an attempt to assess the impact of availability bias, researchers looked at the stocks on the
New York Stock Exchange over a three year period. They put the top 35 performing stocks
into a “winner’s portfolio” and the bottom performing stocks into a “loser’s portfolio.” Over
the next three years, the loser’s portfolio outperformed the winner’s portfolio by almost 25%
on a cumulative basis. The researchers concluded that investors piled into the “winning”
stocks during the initial three year period based on short-term performance while investors
stampeded out of the “losing” stocks for the same reason. Once another three years had gone
by, however, and the short-term performance headlines had faded a bit, the stocks reverted to
something more closely resembling their fair market values.
One way for an investor to dodge System 1’s availability bias is to develop an asset allocation
that makes sense based on his/her unique financial goals and then stick to it. Sticking to an
asset allocation plan forces an investor to sell “winning” asset classes and buy “losing” asset
classes systematically without regard to the latest headline, greatly reducing the influence of
emotions.
Making small tactical adjustments to the asset allocation from time to time can make sense,
so long as it is done on the basis of fact and not emotion. On occasion, an asset class will fall
out of favor, perhaps because an attention-grabbing headline scares investors away from it.
In such a case, it may be wise to invest more money in that asset class until the market calms
down. So long as those tactical shifts are done in conjunction with a well defined and
objective system, an investor can leverage the availability bias to capture additional upside in
his/her portfolio.
Loss Aversion / Prospect Theory. The average person values gains and losses differently.
Losses tend to cause more emotional pain than gains cause emotional pleasure. As a result,
most people will take more risk to avoid losses than they will take to pursue gains. In the
financial world, this bias causes investors to stick with a bad investment for too long (“it’s
not a loss until I sell”) and to sell out of winning positions before they should (“a bird in the
hand is worth two in the bush”).
To illustrate this bias, researchers conducted an experiment in which participants were told
to assume they have $1,000 to invest and that they have two investment options. Option A1
(“the risky option”) carried a 50% chance of gaining $1,000 and a 50% chance of gaining $0.
Option A2 (“the sure thing”) had a 100% chance of gaining $500. When faced with
mathematically equal choices of gaining money, a strong majority of participants chose the
guaranteed return of Option A2. Next, the researchers asked the participants to assume they
had $2,000 to invest and that they had two different investment options. Option B1 (“the
risky option”) represented a 50% chance of losing $1,000 and a 50% chance of losing $0.
Option B2 (“the sure thing”) had a 100% chance of losing $500. When faced with
mathematically equal choices of losing money, most of the participants picked Option B1,
which at least gave them a chance of not losing money. The researchers concluded that
investors will tend to “cash out” when faced with a gain but will “let it ride” when faced with
a possible loss.
One of the best ways to avoid being unduly influenced by loss aversion is to take a fresh look
at your portfolio on a periodic basis without regard to whether your positions have gains or
losses. For each position, ask yourself if you would buy the investment at its current price.
If based on objective information you think that the security is overvalued, you should sell it,
regardless of whether such sale results in a gain or a loss. This approach works especially
well in a Traditional IRA, Roth IRA, 401(k), or other tax sheltered vehicle where you do not
have to worry about the impact of capital gain taxes.
Conclusion: The key to making optimal financial decisions lies in understanding how
System 1 can affect your thinking and then making a deliberate decision to engage System 2.
This is easier said than done, especially when your decisions will determine whether you are
able to achieve your most important financial goals. Your Daintree advisor can help you
gain the perspective you need to avoid the pitfalls of System 1 and benefit from the wisdom
of System 2.
Suggested Reading:
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Duhigg, Charles. The Power of Habit: Why We Do What We Do in Life and Business.
New York: Random House, 2012.
Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux,
2011.
Kinnel, Russel. Mind the Gap: Why Investors Lag Funds,
http://news.morningstar.com/articlenet/article.aspx?id=582626, February 4, 2013.
Richards, Carl. The Behavior Gap. New York: Penguin Books, 2012.
Thaler, Richard H. and Cass R. Sunstein. Nudge: Improving Decisions About Health,
Wealth, and Happiness. New York: Penguin Books, 2009.