The Psychology of Investing

It is only recently that the concept of human nature has been applied to economics, yet its impact can be seen everywhere. Contradicting traditional economic theory, it is believed now that human nature is intrinsic in every action we take from the small scale to the large. The recent GameStop trend was fuelled by individual investors taking an opportunity to turn a profit and retaliate against large hedge funds driving prices down. The actions of investors are governed by qualities of human nature inherent to all of us, which create certain behavioural biases in our minds causing us to act a certain way. In the case of GameStop, one of the reasons why the situation grew out of proportion was due to herd mentality; once enough people began investing in GameStop, more people began to mimic the actions of the larger group. Many economic theories attempt to define what exactly composes human nature, and in recent years, behavioural economics has become a popular perspective. Behavioural economics proposes that humans, contrary to classical economics, are not rational beings. Every aspect of the economy is touched by humans’ instinctive nature, and this can be influenced by many factors in each individual.

Traditional economic theory is centred on three fundamental assumptions: 1. People are rational. 2. Individual choices are consistent with expected utility theory. 3. People correctly update their opinions based on new information received. Throughout the 18th and 19th centuries, classical economics, popularised by Adam Smith, was the dominant school of thought.  It focused on economic growth and freedom, advocating laissez-faire ideas and belief in free competition. This was eventually replaced over time with more updated ideas, such as Keynesian economics, which called for more government intervention.

By the 1930s, a number of problems were raised with classical economic theory. First, there is a strong case against the belief that humans are rational. Humans are often inclined to choose immediate rewards over rewards that come later in the future, even when the immediate rewards are smaller. This is known as hyperbolic discounting. Companies often exploit this trait in advertising to ensure that the consumer pays more/spends more time on their product. Free shipping deals are an example of this: “If you buy more than £50, you get free shipping”. If the buyer only has £35 in their cart, they are incentivised to continue shopping to earn the deal. 

Second, humans do not always choose to maximise utility as proposed by classical economics. In a survey at Cornell University reported by the National Bureau of Economic Research, participants were asked to choose different options in certain scenarios (such as going to a music concert vs a friends birthday), and predict which option might maximise subjective well-being. Whilst most people predicted higher subjective well-being for the selfless option in each scenario, they did not always choose that option. For example, 23% of participants predicted that subjective well-being would be higher for a lower-paying, less strenuous job, but opted to choose for the higher-paying and demanding job. The reward of a higher salary was greater than the downside of reduced happiness, which would go against classical economics

Third, the assumption that people correctly update their opinions is contradicted by a number of examples in recent times. For example, from 1995 – 2000, driven by low interest rates, investors pumped money into fledgling internet-based start-ups in the hope that they would soon turn a profit, even though many people were warning about a bubble. All the available information, such as price-earnings ratios, suggested that these companies could not survive, yet many investors overlooked traditional metrics and based confidence on technological advancement, leading to the bubble. This directly contradicts the assumption that people correctly update their opinions according to new information. 

Behavioural economics was developed from the 1950s and has come to oppose traditional economic theory. It proposes instead that humans are not completely rational and that their decisions are influenced by certain behavioural biases.  For example, historically, human survival depended on quick pattern recognition and decisive action. However, when it comes to investing in a world of uncertainty, this can be a hindrance, as we seek to find patterns that may not exist. This is known as a “blink” system, whereas a “think” system involves careful, considered analysis. Behavioural biases can be identified in four main traits: herding – humans tend to mimic the actions of the larger group. Overconfidence – humans tend to overestimate their own ability to successfully perform tasks. Familiarity – we prefer what is well-known to us. Mental accounting – humans tend to separate their money into different accounts. 

These tendencies affect the market in many ways. Herding results in investors reacting to the behaviour of others, rather than careful, rational deliberation, and this leads to prematurely made decisions. Whilst successful investing involves buying low, selling high, herd mentality can lose investors’ money by leading to the opposite (buying high, selling low).  

Overconfidence is an example of the Dunning-Kruger effect, where an individual with a lack of experience overestimates their abilities, and an excellent individual underestimates their abilities, with the belief that what must be simple for them must also be so for everyone. This overconfidence can cause investors to trade too often. A recent study by Russell Investments showed that the average investor’s inclination to chase past performances has cost them 1.8% from 1984-2017.  

Thirdly, human preference for familiarity can result in a home country bias: the tendency to allocate a greater portion of one’s portfolio to assets domiciled in their home country. This limits the amount of diversification in investment portfolios and exposes investors to significant country-specific risk. 

Finally, with brains programmed to seek out simplification and generalisation, investors are often prone to mental accounting, first proposed by Richard Thaler, where individuals view some transactions as more “valuable” than another. This could explain why people are willing to spend more money with credit cards than cash (Prelec & Simester, 2001) because using the card seems less like money. In the context of investing this appears as a propensity to separate money into different accounts, overlooking what the data might suggest. This can lead to naïve diversification. 

On the macro scale, behavioural biases can have a great impact on the economy, and although they may not be direct causes, are the fundamental forces behind almost all economic events. During the Dot Com Bubble, the promise of an unlikely profit caused investors to overlook traditional economic metrics. This is an example of the disposition effect, where investors decide to keep losing investments, maintaining that they will soon revert. Once the Great Depression began, it was further amplified by the lack of confidence in the economy and huge speculation on land and the stock market. In addition to this, once experienced investors realised these stocks were overvalued and began selling them, prices dropped further. People were overconfident when investing in the market, which led to a large amount of speculation; this, in turn, led to the events of Black Thursday, which were further amplified by “herd mentality”. In other words, when people saw a large number of stocks being sold, a rush was created, and over 16 million stocks were sold at a fraction of their original price, causing the economy to collapse. 

Using the principles of behavioural economics, we can see how small cognitive or behavioural biases, when amplified on a large scale can have great consequences. Although applying human psychology to economics is still an emerging field, it remains an exciting and innovative area of study.

“Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.” Jesse Livermore 

Sources: 

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