In his investigation into why the wisdom of crowds does not apply in financial markets, Jeffrey C. Hood concluded that human irrationality was a key factor.
In chapter four of his book, “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” he dug more deeply into the drivers of that irrationality. In part, his thinking reflects academic work in the field of behavioral finance.
Tellingly, he began this chapter with a quotation from Warren Buffett (Trades, Portfolio): “The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.” Hood also referenced Benjamin Graham’s metaphorical character, Mr. Market, who represented all the emotion and irrationality of the market.
What are the drivers of that emotion and rationality? Hood listed nine of them:
Greed or the get-rich-quick syndrome
It is, as he noted, found everywhere; in casinos, in lotteries—and in the stock market. According to Hood, “The stock market equivalent of lottery tickets are growth stocks, where people hope to make large returns in a relatively short amount of time based on some type of growth story for a particular stock.” More specifically, he noted that the average holding period over the past 50 years has dropped from seven to eight years to less than seven months. And he cited recent research that found the anticipation of making a lot of money can be more emotionally rewarding than the actual making of it.
Loss aversion
This is our built-in trait of feeling losses more intensely than enjoying wins. Hood used the example of a person who finds a $100 bill lying on the ground and a person who lost a $100 bill. The person who lost the bill will feel two to three times as much regret as the joy experienced by the person who found the bill. He attributed this to prehistoric conditions, where a loss might have meant the difference between life and death.
Uncertainty problems
The author argued that humans have several tools for coping with uncertainty. One is “recency bias,” which refers to the habit of thinking that trends and patterns observed recently will continue, unchanged, in the future. In the financial markets, this leads investors to think that if the economy is stable and doing well, this will continue indefinitely. Similarly, the boom or bust of today will continue into the long term. He referenced Howard Marks (Trades, Portfolio), who devised two important rules:
- Rule number one: most things will prove cyclical.
- Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
Affect
Hood told us that “affect” is essentially the same as “emotional response” and is a mental shortcut “that allows people to make decisions quickly and efficiently, although not necessarily accurately.” His example is that of investors during market booms, when their greed overrules their fear. Euphoria makes them willingly suspend their disbelief about quick and easy money.
Endowment effect
This psychological construct refers to an inclination to attribute more value to things that we own than to things we do not own. In financial markets, substitute the word stocks for things. Hood reported, “The endowment effect, consistency bias, confirmation bias, and overconfidence bias all act together and reinforce each other, which at least partially explains why people tend to hold on to losing stocks long after a point where they should have sold.”
Anchoring
As discussed previously, anchoring refers to our natural tendency to start the estimation process by “anchoring” or referencing a given number, even if that number is irrelevant or incorrect. In the stock market, investors often use the current share price as their anchor, regardless of whether it is the correct price (intrinsic value). To complicate matters further, stock prices continually change, producing unstable anchor points.
Social influence and herd mentality
Social influence refers to the tendency we have to look to others for guidance in our own behavior. That may involve the thoughts or behavior of others. Following the herd is a form of social influence in which we follow a crowd rather than using our own judgment. Hood warned of an often-unnoticed effect:
“Herd mentality deserves extra mention here because it is extremely powerful, especially in combination with other influences and biases. In fact, herd mentality can be considered as a type of 'amplifying influence.' Whatever the current biases or influences that are currently affecting members of the crowd, herd mentality is virtually guaranteed to magnify their effects.”
Greed and fear
According to Hood, greed is “a more powerful and comprehensive emotion” than the wish to get rich quickly. He also defines it as “the basic desire of people to obtain wealth far beyond one’s basic needs.” Fear, too, is a powerful emotion, one that can freeze our other emotions, making us lose the ability to think rationally.
He added, “Greed and fear, coupled with herd mentality, are largely responsible for the great pendulum-like swings in the stock market between greedy euphoria and fearful depression. This is unlikely to change.”
Lollapalooza effects
Thank Charlie Munger (Trades, Portfolio) for that colorful name and concept; Lollapalooza effect refers to “multiple biases, tendencies or mental models acting at the same time in the same direction to produce a much greater effect.” We’re talking about a phenomenon in which several negative forces amalgamate and magnify misjudgments or irrationality.
For example, “Stock market bubbles and crashes are perhaps the greatest example of a Lollapalooza Effect in action. Stock market bubbles are at least a function of greed and its corollary, get rich quick syndrome, as well as affect heuristic, recency bias, consistency bias, confirmation bias, overconfidence bias, anchoring, and finally, herd mentality.”
Hood wrapped up the chapter by noting, “The goal of the intelligent investor is to be able to recognize these events [irrationalities], as well as the psychological influences and cognitive biases that will inevitably come to bear, and be poised to take advantage of them.” That, he promised, is what the rest of the book will be about.
Conclusion
Despite our best intentions, we are not always rational investors. In this chapter, Jeffrey Hood has outlined nine reasons why we are bedeviled with irrationalities and other counterproductive thoughts and behaviors.
He showed how a host of psychological undercurrents can lead us astray, even when we are trying to do our best. The relatively new field of behavioral finance is shining new light on these hidden hurdles.
There is also a positive side to all this bad news: If we are aware of these pitfalls, we may be able to take advantage of them to improve our investing success.
Read more here:
- Inefficient Market Theory: Knowledge and the Wisdom of Crowds in Financial Markets
- Inefficient Market Theory: Challenging the Efficient Market Theory
- Inefficient Market Theory: The Wisdom of Crowds
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