Now here's the question: how is it possible that there's a major area of human behavior that psychologists are tending to ignore? I speak of the stockmarket, that hive of financial activity where in the time it takes to say 'Who wants to be a millionaire?' displays every conceivable emotion known to Man, including rage, joy, fear, greed, panic, and even lust. But that's not all, as compounding these human reactions is crowd behavior, which regularly exerts its subtle effects producing not just small changes in general market sentiment and decision-making, but vast changes that lead to massive investment bubbles, with major economic ramifications. Time and again the herd moves propelled by these underlying individual and group passions. And, somewhere in the world, this all happens every day. Yet, as exciting as these phenomena are to me and a handful of others, to many psychologists market and financial behavior remains a highly under-researched facet of human activity. It's surprising too, when you consider the irony in the fact that every time some unexplainable event occurs in the financial world, the cry goes up that 'The market functions by psychology!'; as if to say that when it comes to money, psychology takes over when rationality fails, while the minds of men and women cannot hope to ever be fully understood.
As psychologists, understanding behavior is what we're about, and investment activity is rife with many aspects of the human condition that are explicable and that we should be examining. In this article I'm going to discuss some of the reasons why a broad-based investment psychology, though clearly justified, has not yet gained sufficient attention by psychologists, as well as the coverage that I believe this fascinating field of endeavor has. In turn, it is this coverage that provides a blueprint for investors, which demonstrates the methodology for making enhanced financial decisions.
Stopping the money machine from being built
Money is the root of all evil, goes the old saying. And certainly at some level many people make the association between money and something dirty, as depicted in many other sayings and expressions: He made a pile; She's filthy rich; He dropped a load; She lost a stinking packet; He's sh** broke... I could go on but I'll leave it to your imagination to think of more. Form this perspective, though, an academic discipline that focuses on money and investment is not very 'clean' and not at all nice to be involved with. Even the economists have had difficulty here too and have only got away with it by focusing on the link between monetary activity and social consequence. Hence, until the early part of the 20th Century, and the revolutionary work by Keynes and others, financial theory was relegated to a lesser stage, and as for the implications of financial behavior on investment decision-making itself, this was barely acknowledged.
From the point of view of dirt-laden colloquialisms, at least, money it seems has very few saving graces. This is a shame, but it's hard to shift entrenched cultural views that perhaps originate from religious sources over several centuries. Yet, even providing the connotation of 'dirt' can be ignored, money is still either something that you have or don't have. And many psychologists don't have! The reason, as highlighted in the best seller The Millionaire Next Door (Stanley and Danko, 1998), is that those who have spent many years studying towards professional qualifications don't have the opportunity to make large sums of money early in their careers. By the time they do and they're ready to invest, work or other life concerns, such as family, have gained the ascendancy in their outlook. Consequently, they never get the opportunity to gain knowledge of the investment markets, or build up a motivated personal interest, at a time when many other groups of people, sometimes less-educated, make inroads in this field. Young psychologists are therefore gaining exposure to the study of human behavior in many forms but not as applied to investment.
Another reason why psychologists may have previously avoided the field is that though investors represent a discreet group, it's difficult to conduct experiments with them - you cannot easily manipulate the outcome of their financial decisions due to ethical constraints, and you can't always gain access to particular types of investor due to client confidentiality. Nevertheless, there are techniques that are used effectively to elucidate information about investor reactions, and that lead to ideas about ways to improve their performance. Two particularly important approaches are simulation and large-scale surveying. Vernon Smith (2000) of the Arizona Economic Science Laboratory conducted a particularly noteworthy simulation that points to the fact that investors can be trained to control their emotions. Students were given mock accounts and asked to trade on behalf of fictitious clients. Not surprisingly, the students traded prices up and down in wild speculation, throwing money recklessly into the artificial market, their deals based on expectation and emotion. Until, with experience, subsequent trades became less impetuous and the students learned the folly of their initial approach. Other simulations have centered on how investors misreact to news and how ignoring media hype about stocks can be a highly effective strategy (Andreassen, 1995). While Richard Thaler (1998), a professor of finance at the University of Chicago Business School, conducted a survey using the many readers of the Financial Times in the UK as his participants in order to test how investors attempt to second-guess other investors' thinking. The idea was that investors, rather than making informed personal decisions, will tend towards the average market opinion by making their decisions based on what they perceive everyone else's will be.
So research techniques are available. Yet, the reality is that there are few psychologists conducting this kind of study. And when you realize that during the last decade several scientists, such as Hersh Shefrin, Robert Shiller, Daniel Kahneman, Meir Statman, and Richard Thaler, have been developing what is now called behavioral finance, this seems like a serious omission. Furthermore, behavioral finance, though heavily biased to the psychological - in terms of looking at the systematic errors investors make - is, in the main, populated by economists.
Applying behavioral principles to building a money machine
In spite of the dearth of psychologists, behavioral finance has made important contributions to understanding human behavior in the financial arena. Kahneman and Twerski's (1979) work on prospect theory - looking at how individuals weigh up the chance of gain or loss in relation to perceived risk - represents some of the better-known research. Their findings show that although investors may generally try to avoid taking a risk when they're facing the prospect of a gain, when they're facing the prospect of a loss they can actually be drawn to make more risky investment choices. Kahneman later won a Nobel Prize for this. Other important work has centered on loss aversion, where gains and losses are viewed asymmetrically. Simply put, the loss of a pound is felt, emotionally, far more keenly than the gaining of a pound. There's also preferential bias where investors tend towards making decisions that are in accordance with their own preferences and biases rather than solid information. Similarly, the illusion of validity occurs when investors seek confirmatory evidence of personal beliefs in patterns of financial data. While hindsight bias shows that investors will tend to remember and magnify past successes and minimize or forget past failures. These are but a few of the many personality characteristics that cause investors to make systematic mistakes on a regular basis. Moreover, they are not only tied up with overconfidence, where market highs or investment successes can lead to a belief that things will only keep on improving (or will keep on getting worse), but also to overreaction, which underlies crowd effects and forces the markets to move with excessive momentum.
Now couple momentum effects with investor inertia and not only is the irrationally of markets highlighted but it also leads to powerful strategies. An estimated $72 billion is presently invested with US funds applying these psychological principles, and indeed, behavioral finance experts are no longer confined to the universities. One such example is LSV Asset Management in Chicago run by finance professors Josef Lakonishok, Andrei Shleifer and Robert Vishney. Their strategy is to buy quality companies that the market displays a reluctance to trade in, and then wait for momentum to increase. While, Richard Thaler has set up his own mutual fund investment company with Russ Fuller. All these funds have produced annualised returns of between 7.2% and 31.5% in comparison to the Standard & Poors index (Dillow, 2000). When you consider that most UK and US managed funds rarely do better than the market indexes, this is quite an achievement.
Accepting a behavioral approach
A behavioral approach holds out a great deal of promise for our evolving understanding of complex financial markets, not to mention making higher returns on investments, but it goes against what the economists call the efficient market hypothesis. The view taken here is that the price of a stock at any given moment reflects all possible information about that stock. What it doesn't include, as should be apparent from the previous discussion, is the human element. Yet, the EMH is an entrenched concept that has informed the strategies of many financial companies for many years, and has also probably contributed to the inertia of many psychologists who have come into contact with it. But the behavioral approach is gaining ground, especially following the Long Term Capital Management debacle in the States. This hedge fund based its decisions on the Nobel Prize winning Black-Scholes formula for pricing derivatives. And it worked well on the international stage providing a good return. But as Robert Merton and Myron Scholes found out to their cost, only when the market behaved rationally. When the market suddenly shifted, due to various factors including the 1997 Asian crisis and Russia defaulting on a loan soon after, disaster struck. LTCM went belly up to the tune of $3.5 billion and had to be bailed out by the Federal Reserve.
Market rationality or irrationality is undoubtedly a function of psychology. Nevertheless, investment psychology is going to have difficulty advancing until a seed change amongst finance professionals is established. These individuals remain skeptical of what we can contribute, and matters aren't helped by the tendency to equate psychology with therapy, where many publications still center on 'thinking yourself to wealth' rather than objective psychological techniques as a means to achieving investment success.
Amongst the public a significant impetus for a seed change is now the Internet. Never before have so many people, lost so much money, on so much expensive equipment! This is exacerbated by the fact that people often want instantaneous results. Of course, any investment professional worth their salt will tell you that this is impossible on a consistent basis. Yet it doesn't stop individuals trading using short-term tactics - while egged on by brokers who want to earn fatter commissions. There is a certain irony too in the fact that technical analysis with all its pretty graphs and charts is based purely on psychology - which is to say, market sentiment - and because it is, is far less predictable than other forms of longer-term analysis which center on examining a company's published figures. Added problems here are that there's an element of sunk cost bias where speculators and frequent traders have invested time, money or effort in their strategy and so have little desire to change their tactics; and that behavioral approaches are wrongly considered too abstract and far above the understanding of the ordinary investor - which is really double-speak for: Just tell me how to make money… right now!
A wider remit, a versatile money machine
The coverage of behavioral finance extends beyond a categorization of systematic investor errors to such things as the selection of investment managers. Managers are often promoted on the basis of performance with the concomitant high-profile press coverage. However, better performance may be linked to greater financial risk. Consequently, just because a fund's performance hasn't rocketed during a given time period doesn't necessarily mean the manager isn't any good. It transpires, that many managers attempt to get as close to the market averages as possible with the minimum of risk to their funds and their jobs. Makes sense when you think about it, and behavioral finance seeks to redress the balance, though such knowledge is still only minimally used in formulating selection criteria.
But there are other important areas where investment psychology has applicability that isn't covered within the framework of behavioral finance; and for this reason too I prefer the former term. For example, exploring gender differences in investment behavior, and the profiling of investors according to classification systems.
Men, for example, may take more risks than women, but women may actually produce a higher rate of return (Barber and Odean, 1998). Men may also be more confident than women even in the face of market turmoil (Dalbar Survey, 1998), and there is also evidence to suggest that men and women may make different types of investment choices - i.e. men going for more technical-type stocks and women going for more household brand names and clothing companies' stocks. Additionally, women may require a different rate of return to men, have different criteria for measuring a stocks performance (Pain Webber, 1998), and assess their personal investment success differently to men (Pain Webber, 1999). This is all useful psychologically-based information that feeds directly into improving the financial services offered to investors, as it allows products and advice to be better tailored and targeted according to individual needs.
And when it comes to individual needs, we can now also profile investors - for example, according to how cautious or risk-loving they are (Myers, 1999) - and several websites have simple tests that lead investors from the profile results to tailored suggestions of particularly suited types of investment vehicle. You can see how this works at www.psychonomics.com. The profile allows investors to be classified as either: Cautious, Emotional, Casual, Busy, Technical or Informed. And within these categories, investors may have a low, medium, or high propensity for risk.
One particularly sophisticated profiler uses the Bailard, Biehl and Kaiser Five-Way model (Kaiser, 1983). This approach stresses the level of confidence an investor has and their preferred method of action - the way they respond. 'Level of confidence' is reflected in the emotional choices made based on how much an investor may worry about a certain course of action. Investors may range from confident to anxious. 'Method of action' is reflected in how methodical an investor is, as well as how analytical and intuitive they are. This can range from careful to impetuous. Within these ranges, the model defines five personalities: Adventurers, Celebrities, Individualists, Guardians, and Straight Arrows.
Profiling doesn't only allow investors and products to be matched more effectively, but also provides a way to understand investor personality at greater depth. It can be more clearly seen, for example, who is more likely to be a better long-term client, who is more likely to be a contrarian, who is more likely to have a tendency to leave the running of their financial affairs to their advisor, who is more likely to be a 'do it yourselfer', and even which clients are not likely to be good clients at all because they are rash or predisposed to losing their money. In the BB&K research these were often found to be impetuous celebrities, who were prone to follow a 'hot' stock tip on a crowd-fuelled, speculative bubble. In fact, it was found that this class of investor presented less frequently as they had either lost their money already or had accumulated few assets, and so had nothing to invest.
In with the pennies out with the pounds
Clearly, information from experiments and from profiling is beneficial to financial organisations. Likewise, behavioral finance techniques are extremely useful in formulating investment strategy. Yet, as I've found with many members of the public, the question still comes up: Yeah, that's all very well but have you got any hot tips? Well, surprise, surprise, no hot tips. Nevertheless, I hope I've whetted your appetite concerning the usefulness of investment psychology. There is of course a natural association between organizational psychology and investment psychology due to the fact that both are concerned with assessing organisations. However, the field is accessible to many different types of psychologist; and the field is only waiting for you to enter it and make your contribution. For far too long there have been cultural constraints, a misunderstanding of the research requirements, and inertia, that have stopped psychologists from getting involved and now is the time to break the shackles that have restrained the subject in the past. And if the above discussion has still not quite convinced you to make a foray into the field, then consider: Wouldn't you like to build your own glistening, profit-spewing, personal money machine?
Jonathan Myers is a research fellow in investment psychology and behavioral finance at Columbia University. His most recent book is Profits Without Panic: Investment Psychology For Personal Wealth. He can be contacted at:
References and further reading
Andreassen, P., (1995). Kiplinger's Personal Finance Magazine, in Yes, but how do you feel
about this investment? Steven T Goldberg (Aug. 1995) v49, 8.
Black, F., Scholes, M., (1973). The Pricing of Options and Corporate Liabilities.
Journal of Political Economy, v81, 3.
Dillow, C., (Nov. 2000). Investor behavior and the Markets. Investors Chronicle.
Kaiser, R.W. (1983). Individual Investors. Chapter 3 in Managing Investment Portfolios:
A Dynamic Process, John L Magnin and Donald L Tuttle (eds), Warren, Gorham
Kelly, G.A., (1963). A Theory of Personality. W.W. Norton.
Kahneman, D., Twersky, A., (1979) Prospect Theory: An Analysis of Decision Making Under
Risk. Econometrica, v47, 2.
Lea, S.E.G., (Aug. 2000). Making Money Out of Psychology: Can we predict economic
behavior? The Psychologist (V13, 8), British Psychological Society.
Myers, J., (1999). Profits Without Panic: Investment Psychology for Personal Wealth.
Rice, B., (April 1988), Boom and Bust on Wall Street, Psychology Today.
Shefrin, H., and Statman, M., (Feb. 1986). How Not to Make Money in the Stock Market,
Smith, V.L., (2000). Bargaining and Market Behavior: Essays in Experimental Economics.
Cambridge University Press.
Stanley, T.J., Danko, W.D., (1998) The Millionaire Next Door. Pocket Books.
Thaler, R., (1998) Mastering Finance. Financial Times Supplement, FT. Pitman Publishing.
Barber, B., Odean, T., (1998). Boys will be Boys: Gender,
Overconfidence, and Common Stock Investment http://faculty.gsm.ucdavis.edu/~odean/papers/gender/gender.html
Behavioral finance research library http://www.undiscoveredmanagers.com/behavioral%20Finance.htm
Browne, C.H., (1999). Lessons in behavioral Finance. Tweedy Brown. http://www.alumni.upenn.edu/features/pennfinance/browne1.htm
Dalbar Survey, (1998) in Are women better investors than men by Mary Rowland. MSN
Moneycentral Investor. http://moneycentral.msn.com/articles/invest/careful/3102.asp
Lintner, A. G., (1996). behavioral Finance: Why Investors Make Bad Decisions. Yanni-Bilkey Investment Consulting. http://yanni-bilkey.com/measuring/meaup396.htm
Pain Webber Attitude Poll, (1998). Pain Webber http://www.painewebber.com/frames/151_frame.htm
Pain Webber Attitude Poll, (1999). Pain Webber http://www.painewebber.com/frames/151_frame.htm