Nobel Prize winner Herbert Simon referred to the sometimes irrational cognitive processes that humans use to process information and make decisions as “bounded rationality.” However, current-day behavioral economists are more focused on irrationality than bounded rationality. There are plenty of examples of people letting their biases and heuristics wrongly influence their decisions and opinions. For starters, we merely need to pay attention to the partisan interpretation of everything each of the Presidential candidates says in the 2020 election cycle. Some other anomalies that violate the assumptions of the standard economic model:
- If you take a weekend trip to New York City and eat at a restaurant you will likely never visit again, why do you leave a tip?
- Why is the average return on stocks so much higher than the average return on bonds?
- Why are people willing to drive across town to save $5 to purchase a $15 calculator but not willing to drive to save $5 on a $125 jacket?
- Why do people forever make resolutions to stop smoking, to join a gym, to go on a diet, but it lasts about three weeks?
- Why are people willing to pay $8 for a hot dog at a sports stadium but not from a street vendor?
- Why do people buy a new TV on credit when they have plenty of cash in their savings accounts to afford the TV?
- When people go to an event and go to purchase a ticket for $30, and fnd there is, say, $50 missing from their wallet 88% say they will still buy a ticket.
- However, if they already bought the ticket and fnd the ticket missing from their wallet only 46% said they would buy another ticket (Tversky and Kahneman, 1981).
Homo sapiens have been around for 900,000 years. Over time, evolution has endowed us with deep impulses that guide our decisions. The following are a few examples of these impulses:
- Humans use heuristics to make decisions, not rational thought.
- Humans approach and are impatient for expected rewards.
- Humans avoid expected losses.
- Humans place more importance on relative income than absolute income.
- Humans feel an actual loss twice as much as an equivalent gain.
- Humans hate uncertainty.
- Humans are a super-cooperative species.
- Humans have a profound sense of fairness.
- Humans are willing to punish third-party cheaters.
- Humans have inertia; they resist change.
- Humans act into a new way of thinking, rather than think into a new way of acting.
People’s financial decisions are a good example of this kind of irrational behavior. Nowhere is this more evident than in the stock market, especially by investors who are not professionals and even by investors who are professionals. Meir Statman, a finance professor at Santa Clara University, catalogs some of the erroneous beliefs that biased individuals hold about the stock market in a Wall Street Journal article (2020). After publishing an earlier article debunking five myths that amateur investors believe, Statman received feedback from amateur investors who still believed they could “beat the market” (that is, they could beat the performance of market indices, such as the Dow Jones Industrial Average, the S&P 500 Index, or the NASDAQ Composite Index). He aggregated these contrarian comments into six main categories, and I have summarized his response to each.
Average is for losers.
By definition, diversified investors earn average returns. If they choose an Index Fund or an Exchange Traded Fund (“ETF”) they earn the returns of the market. Some stocks deliver low returns and others deliver high returns; these average out to the market return. Undiversifed investors attempt to pick good stocks and shun bad ones, leading to higher than market returns. In reality, though, they only think they earn higher returns.
OK, but I know what I am doing.
One reader contended that a person who has run a business will have acquired skills such as reading a financial statement, knowing what makes a company successful, or other types of business acumen that will help them pick good stocks. Statman retorts that playing the stock market game as an amateur is like playing tennis against a top-seeded professional.
Reward requires risk.
Another reader says that to reap higher returns you have to take higher risks, and that this is just the nature of the market. Statman says that in order to reap higher returns with an undiversified portfolio, you need luck not skill. A diversified portfolio will gain when the market gains. An undiversified portfolio may take a dive even when the market is gaining and decimate your portfolio.
Time itself is a diversification.
Another reader advocates holding stocks for five years or more, implying that the risk of any portfolio declines over time. This is not true, says Statman. Even a diversified portfolio can lose value over time, due to some companies going out of business. But a single stock or a small portfolio can be subject to many things over a longer horizon that can decrease its value. Competition could rise, or perhaps an innovation disrupts its market. Even Tesla, a current high-flying stock, is about to get a deluge of electric vehicle competitors from 2021 to 2025.
Dollar-cost averaging is another form of diversification.
One reader suggested you invest the same amount every month in an S&P 500 mutual fund. This is known as “dollar cost averaging.” Statman argues that the only value of dollar cost averaging is reducing your regret should you change your mind over the course of a year. For example, if you invest 10% of your cash on the first of every month, you will still have 100% of your money invested at the end of 10 months. If you invest in a diversified fund, you have the lower risk of a diversified fund. If you invest in an undiversified portfolio, you still bear the higher risk of that undiversified portfolio.
Just pick stocks of good companies.
Is Tesla a better company than General Motors? Maybe, by environmental criteria. On the other hand, is General Motors stock a better buy than Tesla stock? Definitely yes, by any standard fundamental stock market analysis. Tesla is way overvalued in relation to its earnings; GM is not. Whether a company is “good” is certainly important, but whether or not a stock is a good buy is much more important to investing. That is, if you want to make money on your investment. Statman reports that a study of Fortune magazine’s “America’s Most Admired Companies” found that these companies’ stocks had lower returns on average than stocks of spurned companies. Further, there was a correlation between increases in admiration over time and lower returns. (It should be noted, though, that this could be caused by investors bidding up the price when the firms get publicity and therefore reducing the returns).