“Humans are hard-wired to be irrational when it comes to financial decisions. We must understand that, so we don’t become the sucker at the poker table.”

Whitney Tilson’s observation that people make mistakes in managing their money should be no surprise to anybody who has been that sucker, fidgeting with a pair of threes as the card sharp across the table collects what was going to be your latte fund for the next three months.

Mr Tilson, a fund manager, founder of T2 Partners, and an FTWealth columnist, is a proponent of behavioural finance, a school of investment thought that expands the fool-and-his-money theory to a bigger scale.

Behavioural finance maintains that not only do individuals make mistakes with money, they do it in big enough numbers to drag markets with them. But those mistakes are predictable, so it is possible to use the theory to make money.

This may not surprise anyone who paid $118 for shares in Yahoo in January 2000. Behavioural finance promises not simply chastisement for bad investment decisions but a way to avoid making more bad decisions and, more attractively, a way to profit from the bad investment decisions of others.

“For the individual investor, there’s a big yield in terms of holding a mirror and he can see he has more blemishes than he thought,” said Terry Odean, a professor of finance at the Haas School of Business at the University of California, Berkeley. And there are plenty of blemishes. “They trade too frequently, the stocks they sell do better than the ones they bought, and they don’t diversify,” says Professor Odean.

“People take more information than they need to make a decision,” says Chris Coplin, chief investment officer of the US behavioural finance team for JPMorgan. “They like the comfort factor it gives them. They need only five data items but they look for 50. People also suffer from the confirmation bias. They decide whether they like a stock and then look for evidence that confirms that view.”

Mr Tilson says: “The biggest one I observe is overconfidence – 70 per cent of people believe they are in the top half of drivers. They invest in things they don’t understand but convince themselves they do.”

These tics of investment behaviour translate into sizeable changes in the stock market. Robert Shiller, the Yale economics professor, believes that studying people’s tendencies towards overconfidence, confirmation biases and the like is essential to understanding the market. “The earliest articles I did were the excess volatility articles, which were very controversial,” he says. “It was saying that the volatility of markets showed that markets were not efficient.”

Prof Shiller has also noticed other psychologically driven swings in securities prices. “Stocks underreact to earnings news and overreact later,” he says.

Psychology also leads to other market effects such as momentum, where higher prices lead to more buying, which in turn leads to higher prices. The process also works in bear markets, aggravating swings in prices. This can lead to herding.

The technology bubble of the 1990s provides good examples of cognitive flaws, including overconfidence, herd mentalities and stock price momentum.

Behavioural finance has lessons for those who believe in the wisdom of crowds – the bigger the number of people making a decision, the less likely they are to err.

“The wisdom of crowds makes sense when there’s a wide distribution of information or when everybody has an unbiased estimate,” says Prof Odean. “But what happens when people share a common decision bias? Why might they not make the same mistake?”

Mr Tilson agrees: “Every study shows that investors follow the crowd. They say: ‘All these [other] people must know what they’re doing.’ People pile into whatever the hottest fund is and get massacred.” Prof Odean’s advice to avoiding such massacres is to buy low-cost diversified funds such as index funds.

If individual investors are their own psychological worst enemy, the case becomes more serious for professional money managers, who are not immune from the same psychological errors. Mr Coplin says: “They can suffer the illusion of objectivity. Part of overconfidence comes from expertise. The more expertise you have, the more over-
confident you become.”

Mr Tilson says: “My opinion is that 80 per cent of money managers are not suited to be professional money managers. The bulk of the money in this world is managed in a cover-your-ass fashion.”

For institutional investment professionals, the way to make money from behavioural insights may seem pedestrian: screen for value stocks and make sure they are considered by fund managers.

Mr Coplin’s selection method is quite straightforward: “Build a portfolio which has a measurable proportion of value stocks to force them[fund managers] to look at.”

Mr Tilson also recommends value stocks: “For me it means buying a stock for less than it’s worth. Our largest positions today are Microsoft, McDonalds, Wal-Mart and Berkshire Hathaway. They’re four of the greatest companies in the world, and trade at a discount to the rest of the market. You need to go back quite a way to find them this cheap. As recently as a couple of months ago, large caps were trading at the cheapest level in 40 years.”

Large-cap value stocks have been more resilient in the recent downturn, in spite of the fact that they have been out of fashion. Even though holding value stocks now is a contrarian position, acting on the insights of behavioural finance cannot be reduced to doing the opposite of what the herd is doing.

A few funds are now explicitly billed as being based on behavioural finance, among them JPMorgan’s Intrepid Funds and Fuller Thaler funds.

Mr Shiller thinks behavioural finance has limited marketing appeal. “There are few funds that are explicitly behavioural,” he said. “A behavioural finance fund is not a strong marketing strategy. The general person is not impressed with psychology or investment research.” But Prof Odean suspects some will try to call behavioural finance to their aid. “On the institutional side, nobody is willing to tell you how they make money and a lot of people are going to claim they [use behavioural finance] because it’s a good story,” he said.

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