Inside the Mind of the Investor

Let’s begin by assuming that Nobel Prizes point to brilliance. Throughout the 1990s, the creators of so-called ‘modern portfolio theory’ and proponents of capital market efficiency seemed to run away with all the Nobel Prizes in Economic Science: Markowitz, Sharpe, Miller, Merton, Lucas, Mundell and Scholes. All have become household names (at least in investment houses) and all are strong devotees of market rationality.

The members of this illustrious group each contributed to the idea that investors and financial decision makers are a rational and unemotional lot. Savvy institutional investors typify this character study. As a result, modern portfolio theory and conventional explanations of financial market behaviour had little to say about speculative bubbles, panics or uninformed decisions, all of which was dismissed as ‘irrational’. 

Then along came the turbulent fin de siècle, with its extraordinary volatility and vaporization of value. Investors were stung, shocked and poorer. In the U.S., the S&P 500 dropped 45 per cent in 15 months while the tech-heavy NASDAQ fell 68 per cent. In Canada the TSX 300 lost 45 per cent of its value.  We recovered, only to be slammed again in the 2007-2009 implosion of financial markets.

The pricking of market bubbles deflated the egos and the influence of the ‘rationalists’, and more circumspect views soon emerged. Robert Schiller of Yale took the academic and professional finance community to task with his insightful critique, Irrational Exuberance.  In it, he challenges the idea of a market without emotion, arguing forcefully that financial markets are subject to fads, ‘herd behaviour’ and values that often defy a sober explanation in terms of future earnings. If we turn that around, then the players in the market -- even the supposedly savvy ones -- exhibit behavioural patterns that financial research has been reluctant to acknowledge, let alone explain.

As market volatility increased, the Nobel Prize Committee appeared to change its view of what is important and influential in the realm of finance. The Committee seemed almost prescient in 1998, slightly ahead of the dot.com meltdown, when it awarded the prize to the philosopher-economist Amartya Sen, who wrote, among many other humanist works, “Rational Fools: A Critique of the Behavioural Foundations of Economic Theory”.

Even closer to the issue of investor behaviour, the 2002 Nobel Prize went to psychologist Daniel Kahneman. According to the formal citation, Kahneman “integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.”  Titles of some of Kahneman’s works are telling, “New Challenges to the Rationality Assumption”, “Aspects of Investor Psychology” and “The Effect of Myopia and Loss Aversion on Risk-taking”.

Myopia?  Loss aversion?  Such terms suggest that investors are short-sighted and more fearful than we realize.  And yet such common sense views of behaviour seem to befuddle the ‘rationalists’, along with investment advisors and pension planners.  

Understanding how people think about risk ought to be fundamental to how investment advisors deal with clients. In one clever experiment, Kahneman demonstrated that a person unschooled in the mathematical subtleties of risk is likely to make choices that would leave a ‘rationalist’ scratching her head. The novel insight is that a warm-blooded investor dealing with his own financial position (as opposed to the cold-blooded type who manages the finances of others) views a dollar gained quite differently from a dollar lost. Here is how Kahneman did it.  Investors were split into two groups. The experiment was repeated many times, on different subjects:

Group A is offered the following proposition:  Here is $1000. It is yours to keep. Now, please choose between accepting an additional $500 or taking a gamble. The gamble offers a 50:50 chance of winning an additional $1000 or getting nothing.

Group B is offered this proposition: Here is $2000. It is yours to keep. Now please choose between giving up $500 or taking a gamble. The gamble offers a 50:50 chance of losing $1,000 or getting nothing.

The options offered to these two groups have the same expected outcome: $1500. An observer steeped in ‘rationality’ ought to predict no significant difference between Groups A and B in terms of the share of the group that opts for the certain outcome as opposed to the risky gamble. But that is not what happened:  in Group A, 85 per cent opted for the sure gain and 15 per cent chose the gamble.  In Group B, 30 per cent opted for the sure loss and 70 per cent chose the gamble.

What does this tell us?  When people are presented with uncertain gains, they tend to choose the ‘surer’ thing. On the other hand, presented with losses, they tend to take a chance.

This says something significant about behaviour toward risk.

“People are much more sensitive to negative than to positive stimuli,” wrote Kahneman in Aspects of Investor Psychology, co-authored with Mark Reipe. “Think about how well you feel today, and then try to imagine how much better you could feel. There are only a few things that would make you feel better, but the number of things that would make you feel worse is unbounded.”

The upshot is that people are likely to make fundamentally different investment decisions depending on whether the market is perceived to be rising or falling. The primary concern is not the volatility of the market, but the anticipated direction of the market’s movement.

Remember the $1000 or the $2000 that was ‘theirs to keep’ for the experiment subjects? Think of those amounts as the investor’s basic non-financial wealth – the home, employment income between now and retirement and so forth. This is necessary in the experiment in order to avoid the types of drastic decisions that one might have to consider if the outcome represented the difference between comfort and abject poverty.

Investors everywhere have endured stomach-wrenching volatility and financial pain of late. The practical question is how to set strategy from this point on. On this issue, those who examine human behaviour would offer a surprising prediction: in the face of significant losses, investors show a tendency to hang on to their losses and to take on more risk than they might otherwise do. To quote Kahneman and his colleague Amos Tversky, “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.”

It is indeed a challenge to turn such thinking on human psychology into guidance for investors. Perhaps one need only recognize that investors’ attitudes toward risk are not fixed, but rather they change; people become willing to take on more risk in some market settings and less in others.

Following are five tips designed to help informed professionals better serve a relatively uninformed but very interested clientele. The tips are consistent with sound retirement planning and explicit regard for the technical and psychological needs of the individual investor.

1. Distinguish between diversification and balance, but do both
The most venerable advice in investment management is to diversify. Getting rid of diversifiable risk is not only smart, it’s easy; even uninformed investors grasp this. The more complex, crucial and difficult-to-explain part is asset allocation – how much to put into equities, how much into fixed income funds? And then, within the major asset categories, how much should go into, say, growth versus income funds in the equity portion? This is where the naïve investor becomes mystified and where the financial advisor is unlikely to be convincing if he does not understand the investor’s attitude toward risk. What makes sense to the ‘rational’ informed advisor might not make sense to the seemingly-emotional and admittedly- uninformed investor whose wealth and security are on the line.

2. Beware the Law of 1/N
We can draw insight from a remarkably simple line of psychological experimentation that examines how unsophisticated investors make asset allocation decisions. The subject of the experiment, the ‘uninformed investor’, is offered a menu of, say, four funds  – A, B, C and D – and is invited to allocate his savings among them. The funds are described in qualitative terms describing risk, such as ‘low’, ‘medium’, ‘above average’ and ‘high’. There are no restrictions on asset allocation: all the funds could go into A or B or C or D or they could be divided in any manner among the four.

The interesting result is that, almost invariably, people allocate one-quarter of the investable funds equally to each of the available funds. With N funds available, the uninformed investor puts 1/N of available money into each of the funds. This has come to be known as ‘the law of one-over-N’.That result has a certain logic to it. When in doubt, spread the money around. Diversify. Fine, but now let’s skew the risk dimension of the funds offered in the menu. Let’s say the funds are respectively depicted as ‘zero’, ‘low’, ‘medium’ and ‘moderate’. The typical uninformed investor makes the same allocation choice: one-over-N in each fund on the menu. The reader can now guess that when the funds are skewed in the opposite direction, for example, ‘average’, ‘above average’, ‘high’ and ‘very high’, one quarter of the funds goes into each available fund. Regardless of the risk spectrum, the law of one-over-N still seems to hold up.

Such behaviour, with no consistent attitude toward risk, reflects a lack of understanding of the fundamental meaning of risk and its consequences. ‘Risk’ is essentially a statistical concept that is unfamiliar to the typical investor. It ought to be given more meaning, which leads to my third tip.
3. Clarify the consequences of choices Most people do not readily grasp the seemingly-simple concept of risk presented in statistical terms. The typical investor is unlikely to understand cumulative returns let alone variance.

Nevertheless, the fact that the vagaries of financial markets have manageable consequences can be meaningfully represented by spelling out a small number of strategies, each of which leads to a range of outcomes.

The investor will quickly learn that his investment strategy determines the range of possible outcomes: a narrow range of possible outcomes means low risk; wider range, higher risk.  The investor’s existing portfolio is an appropriate place to start. Perhaps with the help of readily available software, an investor’s post-retirement income can be determined under a variety of market performance scenarios. They can be expressed in plain English. “With your current portfolio and schedule of contributions, you will have post-retirement income of $60,000 per year. It could be higher, but bear in mind there is a 30 percent chance that it could be lower than $50,000. There is a 10 percent chance that it could be below $40,000.

Are you comfortable with that?  If not, we can adjust your portfolio so that you can expect post-retirement income of $55,000 per year with only a 10 percent chance that it will be below $50,000 and no chance that it will be below $40,000.” 

The task is to put such technical information into meaningful, practical terms.  A few time-tested rules have graduated to aphorism. One of my favourites, dealing with asset allocation, is tip number four.

4. Hold your age in bonds
A 30-year old should be 30 per cent in bonds (70 per cent in equities) whereas a more mature investor, in her 70s, ought to be 70 per cent in bonds. The point of such a rule of thumb is not to pretend that investment strategy or asset allocation can be reduced to simple tricks, but rather, when the logic is sound and the concept can be conveyed in non-technical terms, then do so. Finally, …

5. ‘Time in the market is more important than market timing’
This statement captures sound empirical principles of securities returns and volatility.  In particular, risk is generally rewarded in time but one must endure shorter term fluctuations. For investment planning, hope is not a strategy; nor is faith. Knowledge is the answer. Understanding one’s attitudes toward risk and preferences in the face of risk is fundamental to sound investment management.  Many latter-day Nobel Prize recipients will cheer you on.

Donald Brean is Professor of Finance and Business Economics at the Rotman School of Management.  An earlier version of this paper appeared in The Perfect Storm (Kevin Press, ed., RM Publishing).

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]