Behavioural Economics 101

“The investor’s chief problem—and even his worst enemy—is likely to be himself.” Benjamin Graham, legendary investor that Warren Buffett attributes all his success to.

Economic theory is based on homo economicus. A fundamentally rational human being.

Behavioural Economics has proven that this fictional character does not exist. Humans are many things, but rational we are not. We are emotional, susceptible to biases and generally poor decision makers.

To make money in the stock market, understanding why we do what we do is far more important than any economic theory.

Today, we will dive into the behavioural biases we all exhibit. We will then implement practices that override our human emotions to ensure good decision making.

67% of investors believe they can beat the market. A statistical impossibility.

Behavioural Economics 101

Let’s dive into some of our behavioural tendencies that lead to bad decisions.

Overconfidence bias: Individuals often overestimate their own abilities, knowledge, and chances of success. This bias leads to excessive trading and the belief that one can consistently pick winning stocks. Hint: you can’t.

Herd Behaviour: People tend to mimic the actions of a larger group, even when they know that following the crowd is not the best course of action.

Anchoring: Individuals rely too heavily on the first piece of information (the "anchor") when making decisions. Investors often say, “when the price drops back to X, I will buy” and then watch as the price sails well beyond X.

Recency bias: People give undue importance to recent events compared to historical ones. This bias can lead to an overreaction to recent market movements.

Loss aversion: People tend to prefer avoiding losses over acquiring equivalent gains. This principle suggests that the pain of losing is psychologically about twice as powerful as the pleasure of gaining.

A short story

John follows a few prominent ‘traders’ on Twitter. He has spent a couple of weekends learning from the ‘experts’ and is looking forward to replacing his day-job with day-trading.

As he is setting up the 17 monitors needed to track intraday prices, he reads about a stock on Reddit that everyone is piling into. He quickly buys the stock with 50% of his wealth. The price shoots up from £50 to £200 a share. He thinks to himself, “wow, I am pretty good at this” and quickly invests his other 50% in 3 more shares.

The price of his first investment falters and as quickly as it rises, it drops. John thinks “when it gets back to £200, I will sell”. It never gets back to £200. 

His other 3 shares are well established companies with strong balance sheets. However, news breaks that a war has started in the Middle East. The stocks plunge and after learning his lesson from his first share purchase, John quickly sells, crystalising his loss.

Feeling scared, John sells his 17 monitors and returns to his day job. He never invests in the stock market again preferring a guaranteed 2% interest in a high-yield savings account.

How to avoid being John 

John exhibited every bias mentioned above and made some terrible decisions.

You are probably thinking “John’s a fool, I would never do that”.

Don’t do that, you are exhibiting overconfidence bias.

Taking Benjamin Graham’s advice from above, the best way to make good financial decisions to take yourself out of the equation. You’re a human and you are fallible to making very bad decisions when left to your own devices.

The perfect, no-emotion, non-human strategy to investing based on data is: 

1. Invest in a target date index fund (see appendix for more info).

2. Set up a direct debit to invest your surplus income every month into the target date fund.

3. Forget you ever did any of this and never look at it again until the day you stop working.

This strategy takes you out of the equation. Overconfidence, herd behaviour, anchoring, recency bias and loss aversion are all avoided.

If society continues to progress and economies continue to grow, you will get a very happy surprise when you stop working. Your investment will have grown to a huge pile of cash because you have avoided these human biases.

However.

The point I have been making throughout this email is: we are all humans.

Only a freaky, once in a generation, homo-economicus type fellow could follow that strategy exactly.

Our task is to get as close to that strategy as possible and understanding these biases helps us do this.

As an emotional but ‘biases educated’ human, my investment process looks roughly like this:

1. 90% of my portfolio is invested in low-cost ETFs that track the S&P500 and the FTSE All World Index.

2. Whenever I have spare cash, I invest it into those two ETFS.

3. I own a couple of individual stocks because obviously I know best.

4. I look at the markets every day and get excited when stocks are on the tear and get a bit fearful when they are falling.

5. Despite my fear, I pile in whenever the market drops more than a few percent in a short period of time.

It isn’t perfect but it’s sustainable.

I give into my human tendencies with 10% of my portfolio and try to be a robot with my other 90%.

So far, my portfolio has doubled roughly every five years, and I will be financially free well before the average retirement age of 65.

Many of my cleverest friends think this strategy is too simple and there must be more to investing. I would argue this strategy takes great skill to follow. You need to be a master of your own emotions. Studying yourself and understanding your weaknesses is harder than learning any complex investment theory.

I will leave you with my adjusted words of Rudyard Kipling.

If you can keep your head when all about you are losing theirs… you will not be a man, my son!

And with investing, the further we can be from man, the wealthier we will be. 

Happy investing and here’s to removing yourself from the equation!

Appendix

What is a target date fund?

A target date fund is one that passively tracks a mix of international stocks and bonds. As you get closer to your targeted retirement age, the portfolio includes more bonds and less stocks. This is to maximise growth when you are young and provide more income as you get older. Please see here for more detailed information.  

If, by Rudyard Kipling

If the reference to Rudyard Kipling went straight over your head, please see his excellent poem here.