The Elephant in the Investing Room: Self-Awareness

Traditional finance is based on the premise of homo economicus viz. An average person has the intellectual ability to process all information and takes optimum decisions to maximize economic well-being. Modern economics however does take into account that this isn’t the case, and decision making is influenced by many factors outside rationale.

There are many aspects about human psychology that make us ‘satisfice’ rather than ‘optimize’ our financial goals. These aspects may include factors internal to people, such as their mental make-up, experiences in life, education to name a few. External factors may include macroeconomic or geopolitical developments experienced throughout lifetime. Sample this. A friend from Bangalore, in their early 30s earning well-invests randomly, wants to retire early with huge wealth, but also splurges disproportionately more in microbreweries et al, observes no investing discipline. And an aunt of mine in her 70s living in the US, has an advisor and a systematic financial plan with an expected age of 100, based on her health. The key difference between these two individuals is self-awareness. I am not trying to predict outcomes here, but one can agree that garbage-in, garbage-out applies to most things in life. You see, it is rather naïve to assume that everyone is one with their financial goals throughout their waking hours.

How individuals and professionals usually behave…

“We think, each of us, that we’re much more rational than we are. And
we think that we make our decisions because we have good reasons to
make them. Even when it’s the other way around. We believe in the
reasons, because we’ve already made the decision.”
Daniel Kahneman

This quote above very succinctly demonstrates the reality of decision-making. The efficient market hypothesis may not hold for many reasons time and again. And human behavior is invariably a contributor.

Herd behavior resulting in momentum in stocks has been documented across stock markets world over. One doesn’t need to try very hard to find stuff like emotional and cognitive biases at play. Probably one of the strongest and most prevalent one is disposition effect. It makes it difficult to book losses on an investment that turned out bad. There are many that even go ahead and add quantities to ‘average it out’. This, without getting into the fundamentals of the stock. Averaging a loss making holding only helps if fundamentals are likely to improve!

I was shocked to hear from a stalwart investor that books on the psychology of money are more meant for retail investors. Overconfidence and reversion to mean bias have been detected amongst investing fraternity. Errors of omissions or commissions have costed professionals their jobs or even company shutdowns. Having knowledge about financial markets does not absolve one of having tendencies.

Confirmation bias, to my mind, is the most pervading form of bias in human beings. Charlie Munger has said that if you come across a nice idea, look for things to disapprove it. But how many of us do that? We are mostly fixated with looking for evidence that only confirms our view. We make endless efforts studying great investors but miss out on behavioural aspects.

Collective psychology at work at organizations and markets…

Periods of market bubbles and crashes are marked by panic buying or selling, with asset prices deviating from fundamentals for longer periods. Investors also tend to operate out of emotional biases like regret aversion (what we nowadays call ‘FOMO’), when prices rise quickly.

The sheer fact that crises and bubbles happen even after repetitive episodes is proof that collective human memory is short-lived. And that humans are prone to falling to emotional traps, despite knowledge. The fact that Long-Term Capital Management (LTCM), a company based out of USA, taught us many lessons about

overconfidence and illusion of control when they took over-leveraged positions and eventually collapsed, gets overlooked. Ironically, this is a fact that was noted by then federal reserve chair Alan Greenspan, who was later found to be in oblivion over the entire period of the extravagant build-up of the great financial crisis.

A research paper by Princeton university on collective delusions in organizations and markets has some alarming findings. Wishful thinking (denial of bad news) is shown to be contagious when it is harmful to others, and self-limiting when it is beneficial. Enron CEO or employees of Bear Stearns didn’t liquidate their heavily concentrated exposures until the last day of the respective companies’ debacle. Similarly, willful blindness (information avoidance) spreads when it increases the risks borne by others. The same pattern of normalizing close calls with disaster shows up as a precursor to corporate scandals and financial meltdowns. In 2004, AIG Financial Services caused the parent company to be fined heftily for a fraud. Yet the same manager was encouraged, until his unit blew up the company four years later. This is also how moral hazards get created in organizations and thrive. Assigning preposterous probabilities to outcomes, has been a common pattern of denial too in epic debacles. These were visible in extremely overconfident statements by CEOs in the 2008 crisis.

They have also developed a model on market exuberance, which is microfounded and psychologically-based account of market group-think, investment frenzies and ensuing crashes. The key result is that investors’ beliefs in the story can then quickly become resistant to any contrary evidence.

Group-think, also by means of reckless decision-making, has been observed as an underlying reason for the global financial crisis (GFC) in 2008 by many. Christine Lagarde has even gone to the extent of saying that had it been ‘Lehman sisters’ rather than ‘Lehman brothers’, the world would probably be a bit different now.

Conclusion…

Between the extreme ranges of levels of self-awareness lie most of the market participants, including seasoned professionals in finance. And that professional background does not necessarily dictate personal awareness or optimize actions. Diversity on the board and female leadership can go a long way in reducing the hazards of group- think.

“Man will only become better when you make him see what he is like.”  — Anton Chekhov

It is imperative to acknowledge that the notion of a ‘Rational economic man’ is far from reality. And that there is enough proof for us to start considering the behavioural aspects. Self-awareness is the overarching understanding that we need to develop about ourselves. It can lead to much better outcomes at an individual level as well as at the organisation level.

For what we think of as an ant, is actually an elephant! And the prices we pay for ignoring are bigger than we realize.

References:

1. https://rbenabou.scholar.princeton.edu/sites/g/files/toruqf3331/files/rbenabou/files/groupthink_iom_2012_07_02_bw.pdf
2. https://www.imf.org/en/Blogs/Articles/2018/09/05/blog-ten-years-after-lehman-lessons-learned-and-challenges-ahead

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”

About the Author 

Jolly is a financial services professional, with over a decade of experience in product management across asset classes. Jolly writes on topics related to global markets,with an objective of simplifying and presenting the dynamics of investing. She enjoys hosting her podcast series ‘Investing & Purpose’. Jolly is a CFA charter-holder and a volunteer with CFA Society India, currently building the society podcast.