Applied Behavioural Finance

Marketfox is committed to helping investors improve their decision-making. Here are some resources to help all of us create an investment process to manage our behavioural biases (instead of the biases managing us!)

Strategies for Making Better Investment Decisions

Measuring Up – Benchmarking for Individual Investors Simple tips to help individual investors benchmark their performance. Good benchmarking is more than just comparing portfolio returns to a market index. It requires carefully chosen, apples-to apples”comparisons. It also creates meaningful feedback which helps investors to learn and to improve their investment strategy.

Effective Benchmarking for Individual Investors – A Case Study How I review the 12-month performance of my stock portfolio. An example of how individual investors can create the feedback needed to improve their investment process.

Managing the Disposition Effect How developing your own personal investment philosophy, improving your self awareness, using checklists, sticking to a sell discipline and focusing on an investment thesis instead of performance can make you a more successful investor.

Behavioural Biases

Are Markets Driven by Fear, Greed or Regret? Regret is a powerful comparative emotion that can underlie both mistakes of commission and omission . How experiencing regret in anticipation of a decision results in mistakes. Managing regret by making the right comparisons. The importance of deliberate practice.

The Disposition Effect – Why it Matters Why do most investors sell their winners and let their losers run? The mathematics of loss and why holding onto winners can make all the difference to your returns.

Prospect Theory – A Beginner’s Guide Why we feel the pain of loss more than the joy of gains. The power of framing and reference points. The irony of taking less risk to protect a gain and more risk to avoid a loss.

Cautionary Tales

Beating the Market Part 5 – Could our behaviour be part of the problem? Why performance chasing (when selecting fund managers) is a really dumb idea. The importance of dollar-weighted versus time-weighted returns.

Investors behaving badly Entertaining stories of investors making bad decisions. The lesson – stick to your investment process!

Academic Links

Conditions for Intuitive Expertise: A Failure to Disagree Daniel Kahneman and Gary Klein compare the Heuristic Bias (HB) and Naturalistic Decision-Making (NDM) approaches to expert decision making. Whether or not experts have skill depends on two factors: 1) the predictability/stability of the activity or environment and 2) the opportunity to learn through feedback.    

Prospect Theory: An Analysis of Decision under Risk One of THE papers that started it all. This Classic paper by Daniel Kahneman and Amos Tversky introduces prospect theory, which explains why we hate winning more than we enjoy winning. The consequences of this are that our reference point matters and that we are likely to take more risk in an effort to recoup a loss and less likely to take risk to protect a gain.

The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence Paper by Hersh Sheferin and Meir Statman that explains why we are more likely to sell our winning investments only to hold onto losing investments. The authors attribute this behaviour to a combination of prospect theory, mental accounting, regret aversion and a lack of self control.

The Behavior of Individual Investors Chapter 22 from the book Handbook of the Economics and Finance Written by Brad Barber and Terrance Odean. Great summary of the research into how behavioural biases affect individual investors. Features the results of several academic studies demonstrating the real-world effects of behavioural bias on wealth.

Anomalies: The Endowment Effect, Loss Aversion and Status Quo Bias Part of a series of papers written by Richard Thaler and Co. As the name suggests this paper introduces the endowment effect (and the famous Cornell Mug experiment), loss aversion and status quo bias.

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Myopic Loss Aversion and the Equity Premium Puzzle Historical returns indicate that equity investors have typically earned a premium of between 3-6% (depending on the country or time period) per year over bonds. Shlomo Benartzi and Richard Thaler explain that this could be due to most investors investment horizon being equal to around 12 months. The shorter our investment horizon, the higher the risk premium we expect. See also A Watched Portfolio Never Performs.

Does the Stock Market Overreact? One of the KEY papers supporting the behavioural explanation for why the value premium (cheap stocks out-perform expensive stocks). Werner De Bont and Richard Thaler demonstrate how momentum (winners keep winning and losers keep losing) and value exist on a time continuum. Momentum is stronger of the short-to-medium-term while value dominates over 3-5 years.

Great Posts from the Web

Even God Would Get Fired as an Active Investor (Alpha Architect) Wes and Jack explain why active management is so hard to stick with, even if you’re omniscient! My all-time favourite Alpha Architect post.

A Watched Portfolio Never Performs (Longboard). Great visual example of why checking the performance of your portfolio frequently. We dislike losses 2x as much as we enjoy gains (Prospect theory).  The stock market is up only 53% on a weekly basis. Add these two facts together and the result is checking your portfolio too often makes you feel like you’re losing money even though your wealth would have increased enormously. Which is why many people find it hard to stay invested for the long-term.

Visualizing the Anxiety of Active Strategies (Newfound Research) Corey expands on Longboard’s research to see what it would feel like if you’d invested in several active strategies (small cap, value momentum and low volatility) and checked your performance at different intervals. Most investors can’t stomach the needless volatility they experience simply because they check the performance of their investments too often.

Woe Betide the Value Investor (Research Affiliates). Great post quantifying the effects of performance chasing. “Over the period from 1991 to 2013, the average return that investors in value mutual funds actually earned was 131 bps per annum lower than the funds’ reported return.” Enough said.

Treasury Bills Outperform Most Stocks – Say What??? (Alpha Architect) Fantastic summary of a very interesting piece of research on the distribution of stock returns. From 1926 – 2015 , less than half of the stocks in the US out-performed the US one-month Treasury bill. Meanwhile 86 stocks (0.33% of the entire universe) accounted for over 50% of the gain of the ENTIRE stockmarket. Why does this matter? Because the disposition effect means that investors are highly likely to sell their winners too soon. Consequently they risk missing out on most of the gains created by the stock market.

Videos

Prospect Theory – Explained in Under 2 Minutes

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