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Nobel winner unearths 5 common investing mistakes
Just as I suspected, investors arent so rational after all. In a breakfast with Nobel winner Daniel Kahneman, I learned of several blind spots that needlessly cost us dearly.
By Harry Domash
I was delighted Oct. 10 when Daniel Kahneman, a psychology professor at Princeton University, won the Nobel Prize in economics for his attempts to explain the quirkiness that governs our financial decisions. (He shared the prize with Vernon L. Smith, economics and law professor at George Mason University in Virginia.)
Delighted, because it was a victory for what is still a fairly new field of economics -- called behavioral finance -- that can help all of us learn to become better investors. Not so many years ago, traditional economists spurned people like Kahneman as heretics. These traditionalists argued that human financial behavior is governed by utility theory, which is something like common sense.
In other words, economists believed that each of us acted in a rational way to improve our overall wealth, or as The New York Times put it: That individuals make decisions systematically based on their preferences and available information in a way that changes little over time.
I knew that was bunk and was thrilled to have luminaries like Kahneman agree that when it comes to money, people behave irrationally. They buy a stock because they think they know more than the next guy. They second guess themselves and trade too much. They sell their winners instead of their losers. They make bad decisions just to avoid a loss.
Money and irrational human behavior
Five years ago, when I was doing research on behavioral finance, I went to a conference on the topic at Harvard University and had breakfast with Kahneman before his presentation to learn more about his work.
My own experience as a financial journalist showed that people were almost totally irrational about money. They put money in savings accounts while they ran up credit-card debts. They jumped into the market when it was riding high and sold at the bottom. They earmarked certain accounts to be treated in totally different ways. I knew this, but Kahneman is a scientist, and I wanted to hear his proof.
The traditional economists believe that we have a well-functioning stock market, Kahneman said. Buying a stock is like going to the grocery store. You dont have to worry whether the tuna fish and peanut butter are priced right because other people have worked all that out and the store has learned to put the right price on its merchandise. So it is with Lucent Technologies (LU, news, msgs) and Dell Computer (DELL, news, msgs).
In a well-functioning market, stocks are by and large priced right, these economists say. They call their reasoning utility theory.
Investors and their blind spots
Kahneman had trouble with just about every part of the theory. Utility theory assumed that people try to maximize their wealth over a very long time frame and that they are risk-averse.
But Kahneman found that people rarely think in terms of total wealth. They think of making money and losing it over the short term or in a single stock. That pattern was clear over the last few years when people doubled their money from 1998 to 2000 and then lost a big chunk of it from 2000 to 2002. How many of them looked at their total wealth in 1997 compared to their total wealth in 2002? Very few. They looked at their March 2000 statement at the market peak; everything after that was downhill.
Kahneman has identified five colossal mistakes investors make:
Investors are overconfident. People think they know more than they do. Whether they get a tip from the barber or the message boards, they think theyre smarter than the next guy, and they trade on it.
Investors are often shortsighted, focusing on short-term gains and losses. This trait results in too much trading, which is expensive. The more you trade, the worse off you will be.
Investors segregate accounts rather than looking at overall wealth. People put money into a saving account for college, a retirement account, a family home and a second home, then tote up gains and losses in each one. Sometimes, they even segregate each stock and expect every one to be a winner. Increasing your overall wealth means looking at the entire financial picture. Its important not to focus only on the stock loss in your 401(k). Think about the appreciation in the value of your home and how your overall wealth has changed. Perhaps when the stock market stinks, you might be better off investing in a home renovation.
Investors take the inside view rather than the outside view. People typically have a very rosy view of their own skills and their own chances. For example, Kahneman said he once sat on a committee that planned to write a textbook. The committee estimated that the project would take 2 1/2 years. But it did not account for illness, divorce, delays, defections and the other troubles that stretched the project out to eight years. It was then abandoned. Likewise, we look at our own prospects without accounting for the downside.
Kahneman has done experiments in which he asks college students about their chances of developing breast cancer or becoming an alcoholic. Most students put their own chances very low. They give their roommates a much higher chance of both cancer and alcoholism. In fact, the two students probably have equal chances, but we tend to see our own prospects as rosier.
When Kahneman asks a group of people to assess their driving skills, 90% of the people in the room usually say they are above average. In yet another example, he says that if you ask new business owners about their chances of success, two-thirds of them think it is 70% or higher, and 25% think success is certain. In reality, he says, 65% of new businesses fail in the first five years.
Kahneman says this kind of optimism can be important, since optimistic people tend to succeed. But unrealistic optimism is misplaced in the financial markets because optimism leads us to believe that we know something special about the stock we are picking, or that we can see it is mispriced while no one else can.
Investors often sell the winners and hold the losers. Kahneman cites an experiment that examined the stocks people bought and sold over a one-year period. The stocks they sold outperformed the stocks they bought by 3.4% (without considering transaction costs).
The truth is that investors dont like to recognize a loss. I know I dont. One strategy they use is to wait for a stock or a mutual fund to get back to even, reasoning that they havent lost anything. This shortsighted approach ignores the opportunity cost, or what else they might have done with their money in the meantime. And the reluctance to recognize losses affects professional managers as well as amateur investors, Kahneman says. Accepting a loss and moving on is very difficult.
Kahneman does not suggest we all become pessimists. But he does wonder if we should pay more attention to the outside view, or to a realistic assessment of our situation.
This optimistic bias is real, very serious, and it controls the behavior of the individual investor as well as the professional analyst, he said. It affects all of us in just about everything we do, and thats something we might want to think about.
As for me, I'll bear Kahneman's findings -- and their new credibility -- in mind when I'm tempted to make a quick money decision. Being irrational isn't all bad. After all, we don't want to be robots. I suspect creativity and uniqueness is tied to irrationality in some ways. But let's try to set our money decisions aside when we get irrational. More trading, more action, more decisions do not translate into more gain. When in doubt, stay the course.
At the time of publication, Mary Rowland owned none of the securities mentioned in this article.
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