Behavior and Investment Returns

BEHAVIOR + INVESTMENT RETURNS

HOW HUMAN BEHAVIOR LEADS TO INVESTMENT ERRORS

Evolution of our brain. The human brain has not evolved much in over 200,000 years. Back then the brain developed to identify patterns to ensure survival e.g. Where to hunt? Where to hide to avoid lightening? Where to find water?

• This ability to identify patterns leads to mispricing of assets.

• When Netflix stock goes up two days in a row we are conditioned to think that the trend will continue and Netflix is bound to go up many more days. This leads people to buy the stock that enforces the trend and creates “momentum” for the stock. This trend following pushes the market price of Netflix beyond its intrinsic value.

Using the past to predict. Another behavior that leads to mispricing of assets is a tendency of investors to anchor their views of a fair price to the prior price level.

• When Apple introduced the iPhone many investors did not appreciate the magnitude of the impact this would have on Apple stock.

• They “anchored” their estimate of Apple stock to the price prior to the introduction of the iPhone and either sold or did not purchase the stock.

Losing is painful. Losing is two times as painful as winning is pleasurable to investors. Therefore, investors tend to confirm their winners and hold on to losers.

• Investors have a “disposition” to sell their winners early.

• Losing positions are not sold even in the face of prices greater than an asset’s intrinsic value.

Identifying these behavioral anomalies and acting upon the deviation of an asset’s market price from its intrinsic value can be profitable. Because this often results in taking contrarian positions it can also provide important diversification benefits to a portfolio.