Psychologist has our number
The theory behind
stupid investments
CBS MarketWatch,
5-31-03
WASHINGTON (CBS.MW) -- The Gadfly has a new investing hero.
As far as I can tell, he's never recommended a single investment and never told anyone how to get rich. But he can explain why both individuals and professionals make so many bad investment decisions -- and that might help us avoid repeating some of them. My new hero is Daniel Kahneman, the Psychology 101 professor at Princeton University who won last year's Nobel Prize for Economics.
I had the chance to hear Kahneman when he spoke last week at the annual meeting of the Investment Company Institute. He told a crowd of people who make their living selling and managing mutual funds some things they probably won't be passing on in their next advertisements.
"Most of the risks that people take are because they're deluded," he said bluntly. "We expect of life (and our investments) more than life is going to deliver."
And that's why we're endlessly, and foolishly, chasing investments that have been performing well recently and are likely to perform less well in the future. That's why we listen to television pundits and search for hot investment information on the Internet. That's why we pay attention to fund advertisements. We think we're being informed, but there's a good chance we're being mis-informed.
What does average mean?
Most individual investors, most fund managers and most financial advisers think they're smarter than average and can make better than average investment decisions. They're wrong, of course. At best, most of us are just average. That's what the word means.
But if investors and advisers didn't think they were better than the average Joe, there would be no reason to pick one investment over another and more money would be in index funds.
We know that everybody can't be above average, it's just statistically impossible. But when Kahneman asked the audience of investment professionals how many of them thought they were in the top 10 percent, it was pretty clear from the reaction that most thought they were. And there's the problem.
"People do things and make bets that make sense only if they think they are better than average," Kahneman said. But in reality it's just as likely that if you're buying, the person selling knows more than you.
And even if you are above average, he added, "people underestimate the role of chance in their outcomes."
Obstacles to smart investing
It turns out that over-confidence in our abilities is just one of the obstacles Kahneman has identified that keep us from making smart investment decisions.
Working from real-world observations and real-people surveys - rather than from economic theory -- the psychology professor and his colleagues discovered that many economic decisions are not rational.
He developed "Prospect Theory" which includes the principle of loss aversion. With a series of experiments in the 1970s, long before anyone heard of an Internet bubble, Kahneman and his research partner Amos Tversky observed that losses affect a person 2.5 times as much as gains.
They showed that to take the chance of losing $100, most people want the chance to win at least $250. It's not so much that we want to win, we just hate to lose. And we hate even more to admit we've lost -- hence the irrational presence in our portfolios of stocks and funds that are worth a fraction of what we paid for them.
Kahneman says investors are also kept from good decisions by what he calls excessive certainty. "It turns out," he told the fund industry gathering, "when people are 99 percent sure about something, they're wrong 15 to 20 percent of the time."
The professor's investments
The professor did have some good news for the professional adviser crowd. He thinks the fact that "advisers are less loss-averse when someone else is losing" can improve their advice -- as long as the advice isn't based on overconfidence.
In other words, an adviser might be more willing to recommend selling a losing investment -- but that can be countered by the fact that the adviser may have recommended the investment in the first place and have excess confidence it's going to turn around.
When Kahneman was asked about his own investing success or failure, he acknowledged making the same mistakes his research warns against.
He didn't give specifics of his own investing strategy, but Bloomberg reported in a profile earlier this year that Kahneman uses a professional adviser -- and most of his money is in index funds and Treasury Inflation Protected Securities.
There might be a lesson in that.
(If you want to do some serious reading about Kahneman's Nobel-winning work, the Swedish Academy of Sciences has an introduction here.