Tag: behavioral-finance

Is it rational to be irrational?

Not losing is winning.

“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do.” – Charlie Munger

In 2002, Daniel Kahneman won the Nobel prize in economics for his groundbreaking work in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty. In 2017, the Nobel prize in economics went to his long-time collaborator, Richard Thaler, for exploring the biases and cognitive shortcuts that affect how people absorb and process information. Their books, Nudge, Misbehaving, Thinking, Fast and Slow, went on to become best sellers and hugely influential.

When it comes to investing, their biggest observation is that people prefer to avoid losing compared to gaining the equivalent amount.

This leads to poor investment outcomes because investors use their “lizard brain,” ignoring probabilities and expected returns.

Context matters

Imagine, you are asked to spend a month in a deserted island that has no food. You are allowed to fill a sack with anything you want and take it with you. What will you fill it with?

The “rational” answer is potatoes. It is one of the most nutritious vegetables known to us. It is a good source of many vitamins and minerals, such as potassium and vitamin C. Aside from being high in water when fresh, potatoes are primarily composed of carbs and contain moderate amounts of protein and fiber. (Potatoes 101)

Now, what if you are allowed to take 7 sacks? A normal person would probably still fill one sack with potatoes but go on to fill the other 6 with different types of food. After all, who, in their right mind, would like to eat potatoes every day for 30 days? Economists, however, would label this person “irrational” because he did not take 7 full sacks of potatoes with him.

Rationality is context dependent. By viewing all decisions from within a context-independent model, an economist might arrive at the conclusion that people are irrational. But, so what?

Prospect in Theory but not Prosperous in Practice

Prospect theory, summarized in the chart above, simply states that carriers of value are changes in wealth or welfare – rather than final outcomes. In theory, a smart investor should be able to exploit this irrationality, along with a million other behavioral weaknesses, and make bank. But in practice, the theory has been a bit of a let down in that area.

Thaler is a principal in Fuller & Thaler Asset Management Inc. that runs $6.1 billion in the small-cap Undiscovered Managers Behavioral Value Fund and $261 million in the Fuller & Thaler Behavioral Small-Cap Equity Fund.

After 5 years, these funds haven’t beaten a simple market-cap weighted small-cap ETF.

Fat-tails and Geometric Compounding

In the markets, it is entirely possible to lose years of returns in a single month. Low probability events with high severity can wipe out even the smartest investor.

Combine this with geometric compounding – a 50% loss requires a 100% gain from the bottom to bring the investor to break-even – and the preference to avoid losses doesn’t look that “irrational.”

The model, silly!

Perhaps, the problem is not with people but with the model being used to judge them. There is a big difference between tossing a hundred coins simultaneously and tossing them one after another. Behavioral economics uses a flawed model that treats them the same and labels us “irrational.” But, if you look at the world through the lens of non-ergodicity, actual investor behavior is not too far off the mark.

To make an economic decision, I want to know how my personal fortune grows or shrinks under different scenarios, not how the average person’s fortune grows or shrinks.

I don’t care that the average person “wins” at Russian Roulette, I care about what happens to me if I keep playing over time. Taylor Pearson


While the field of behavioral economics is interesting and it’s a good insight to how people behave in business and investing, one should ask themselves that if bad behavior is so pervasive, then (a) how come investing using that model has been a failure, and (b) if the model labels everything it sees as bad, then perhaps the model itself is wrong?

Why Anomalies Persist

Academics label momentum as an “anomaly.” Multiple studies have shown that this anomaly has persisted over long periods of time and across markets (AA). Based on this insight, quite a few quantitative momentum funds sprung up. And since nothing good is ever left alone at Wall Street, a whole bunch of momentum factor ETFs launched to ride the wave during the recent bull market. Currently, there are more than 40 momentum ETFs listed in the US.

So, does this mean that the momentum anomaly has been arbitraged out? After all, with over $12 billion in momentum ETFs alone, shouldn’t the strategy have topped out? We posit that it is unlikely to happen anytime soon. Why? Because investors just can’t help themselves.

Consider the asset under management (AUM) of these momentum ETFs. If, for an ETF, the price is down 10% and its AUM is down 20% over the same period, it means that there has been a net outflow of 10%. If you run this math on all the momentum ETFs traded in the US since October this year, you end up with about $2 billion in outflows in 3 months. That is roughly 11.5% of momentum assets on the 1st of October.

It has been well documented that investors chase performance, often piling into “hot” funds and strategies and exiting on the slight whiff of under-performance. We are seeing this in action on momentum ETFs. And as long as investors are caught in this doom-loop, momentum (and by extension, value, investment and volatility anomalies) will persist.

Also read: Investor education is a waste of time (Aug, 2014)

Code and data are on github.

The Walter Mitty Effect

Walter Mitty is a fictional character in James Thurber’s short story “The Secret Life of Walter Mitty.” Mitty is a meek, mild man totally intimidated by his overbearing wife. He deals with it by daydreaming that he is transformed into a courageous hero.

Investors are a bit like Walter Mitty, says social psychologist Dean G. Pruitt. When the market is doing well, they become brave in their own eyes and eagerly accept more risk. But when the market goes down, they rush for the door. So when you ask an investor directly to explain their risk tolerance, the answer comes from either a fearless bomber pilot (in a bull market) or a henpecked husband (in a bear market).

Source: http://pruitt.socialpsychology.org/

Your Friends may be your Portfolio’s worst Enemy

Consider this:

  • People who live near each other increase their ownership of stocks around the same time.
  • 401(k) investors put more money into stocks when their co-workers have recently earned high returns that way.
  • Mutual-fund managers are more likely to invest in a company when other stock-pickers in the same city are also buying it.

Nobel Prize-winning economist Robert Shiller found that for 62% of individual investors and a shocking 75% of institutional investors, the decision to invest in stocks with hot recent returns had nothing to do with a “systematic search.”

Instead, these investors seemed to chase whatever grabbed their attention the most because other people were talking about it.

And it is not only in investing. “Group attention” – the experience of simultaneous co-attention with one’s group members – increases emotional intensity relative to attending alone. Greater fear, gloom, and glee is a result from group attention to scary, sad, and happy events, respectively.

Individuals come to feel more when they are together.


Investor education is a waste of time

When you read about Ponzi schemes, “chit funds”, teak plantations, ULIPs, variable annuities, etc… you might be led to think that these are because people don’t know any better. So maybe we only try and educate them, they’ll know how to spot these scams and stay way from them. However, that doesn’t seem to be the case.

Ponzi schemes are everywhere

You would think that in the US, after all the billions of dollars spent on education, regulation and enforcement, people would know better. From ponzitracker.com:

Nearly six years after the word “Ponzi scheme” became a household name thanks to Bernard Madoff, Ponzi schemes continue to proliferate and leave a trail of financial destruction in their wake as demonstrated by newly-compiled data showing more than $1 billion of newly-uncovered schemes and over 600 years in prison sentences handed down in the first half of 2014. In the first six months of 2014, at least 37 Ponzi schemes were uncovered, with a total of more than $1 billion in potential losses. This equated to the discovery of a Ponzi scheme (1) more than once per week, (2) every 4.9 days, or (3) every 118 hours. Included in this list are at least three Ponzi schemes with estimated losses of at least $100 million or more, with the estimated $300 million in losses in the alleged TelexFree Ponzi scheme ranking as the largest Ponzi scheme exposed in the first half of 2014.

“Real” Finance is strange

Morgan Housel at fool.com:

  • People are ignorant around costs.
  • If I want to be a firefighter, I need extensive training. If I want to manage the firefighters’ retirement fund, I need a nice suit and a sales pitch.
  • Finance is filled with people who remain in business despite awful track records.
  • Finance is taught overwhelmingly as a math-based field, in which students learn how to calculate beta by hand and dissect a balance sheet in their sleep. In the real world, finance is overwhelmingly a psychology-based field, where the best investors are those who control their emotions.
  • There are few other subjects in which people have an obligation to understand something, yet so many willingly choose not to.

The Behavior gap is as wide as ever

In the US, over the past 20 years, “equity fund” investors achieved an average 5.02% annualized return, which is 4.2% less than the 9.22% that he/she could have achieved by simply investing funds in an S&P500 index-tracking fund.

Investors chase performance. Here’s how Vanguard simulated performance chasing behavior in a recent study:

Initial investment: At the start of the analysis period, we invested in any fund in existence for the full three-year period from 2004 through 2006 that had an above-median three-year annualized return.
Sell rule: Using three-year rolling periods of returns, we moved forward one calendar year at a time. Funds that achieved below-median three-year annualized returns at any time were sold, as were funds that were discontinued.
Reinvestment rule: After any sale, we immediately reinvested in each fund that achieved an average annualized return within the top-20 performing funds in the style box over the prior three-year rolling period.

Here are the results:

performance chasing

Sounds legit

Real Step Pashupalan brought to you by Step Up Marketing Pvt. Ltd (SUMPL) (Source)

SUMPL is engaged in rearing of livestock mainly goats etc. for its customers long with the rearing of the livestock, SUMPL has also been selling livestock to the customers for a consideration wherein the purchaser has the option of keeping the purchased livestock with SUMPL for breeding and rearing purposes only for a period of 3.5 years as per the terms and conditions laid down in the application form given to the purchaser at the time of purchase of the livestock. In case the purchaser of the livestock decides to keep the same with SUMPL for rearing, a Certificate of Goat Keeping would be issued by SUMPL bearing a registration number against the goats which purchaser opted to keep with them.

And if owning goat certificates is not your thing, how about real estate? Viswas Real Estates and Infrastructures India Limited (VREIL) came out with these gems: (Source)

  • Own Your Property Advance Scheme Monthly Plans
  • Lumpsum Property Advance Schemes
  • LPAS-MIS Platinum Plan, and
  • Own Your Property Advance Scheme (Daily) Plans

It was sort of like a layaway plan for real estate combined with insurance. The customer pays a monthly installment of 500/- which at the end of the year becomes 6,000/- which is the total property advance paid. On this amount, the estimated compensation value (ECV) is 600/- and thus, the refund amount with ECV after one year is 6,600/-. On receipt of the total advance amount, VREIL executes simple mortgage deed (without possession) in favour of the investor. VREIL also offers insurance coverage in conjunction with its schemes.

Yes, regular people invested in these plans and SEBI recently busted them.


Regulators and policy makers would do well to study the behavioral and psychological forces that cause investors to make irrational decisions. The focus so far has been on the brain, it should be on the investors’ hearts instead.