Your Brain Is Bad at Investing: Behavioral Finance

Up to this point in the book, Malkiel has described theories built on a simple assumption: investors are rational. They weigh risks, calculate value, and make sensible decisions. Chapter 10 throws all of that out the window. Because here’s the thing. People are not rational. And two psychologists, Daniel Kahneman and Amos Tversky, spent decades proving it.

Their work basically created the field of behavioral finance. Kahneman won the Nobel Prize in Economics for it in 2002. He wasn’t even an economist. That tells you something about how well economists understood human behavior before he came along.

We All Think We’re Above Average

The most basic human bias is overconfidence. Ask a room full of college students if they’re better drivers than average. 80 to 90 percent will say yes. Ask random men to rank their ability to get along with others. 100 percent put themselves in the top half. 25 percent said they were in the top 1 percent. Even for athletic ability, only 6 percent of men rated themselves below average.

Now apply that to investing. People overestimate their stock-picking skill, underestimate the risks, and exaggerate their ability to control outcomes. Kahneman tested this by asking investors to set confidence intervals for where the Dow would be in a month. Results should fall outside their bounds about 2 percent of the time. In reality, surprises happen about 20 percent of the time.

This overconfidence leads to overtrading. Terrance Odean and Brad Barber studied thousands of brokerage accounts and found a clear pattern: the more people traded, the worse they did. And men traded more than women, with worse results to show for it. Warren Buffett’s advice applies here. Lethargy bordering on sloth remains the best investment style.

There’s also hindsight bias. You remember the time you “knew” Google would take off after its IPO. You forget the six other picks that went nowhere. Success gets filed under skill. Failure gets blamed on bad luck or unusual circumstances.

Biased Judgments and the Illusion of Control

Beyond overconfidence, people struggle with basic probability. Kahneman and Tversky showed this with the famous Linda problem. You read a description of a woman who sounds like a feminist activist, then get asked: is it more likely she’s a bank teller, or a bank teller who is also a feminist? Over 85 percent picked the second option. But that violates a basic rule of probability. The chance of being A and B can never be higher than the chance of being just A.

People also believe they can control random outcomes. In one experiment, subjects used a device to keep a ball in the upper half of a screen. The device wasn’t even connected. The ball moved randomly. Afterwards, players were still convinced they’d had real control. The only ones who didn’t fall for this were those diagnosed with severe depression.

This illusion of control is what makes chartists believe they can predict stock movements from past prices. They see patterns in randomness and trade on them.

Herding: Following the Crowd Off a Cliff

Groups can sometimes be smarter than individuals. That’s how free markets work. Millions of decisions aggregate into reasonable prices. But groups can also go insane together.

Solomon Asch proved this in the 1950s. Show people two cards with lines and ask which lines match. Easy question. But plant six actors who all give the wrong answer first, and suddenly the real subject starts agreeing with the obviously wrong answer. A later brain scan study found something worse. People who went along with the group didn’t just cave to social pressure. Their brains actually changed what they perceived.

Apply this to investing and you get the Internet bubble. Friends at work bragging about their tech stock gains. Media hyping every new IPO. A positive feedback loop where rising prices attract more buyers, which pushes prices higher, which attracts even more buyers. Until you run out of greater fools.

The data backs this up. In the twelve months before the market peaked in March 2000, more money flowed into equity mutual funds than ever before. At the market bottom in fall 2002, investors pulled their money out. They bought at the top and sold at the bottom. Dalbar Associates estimated this timing penalty cost the average investor over 5 percentage points per year compared to just holding an index fund. Even professional fund managers aren’t immune. They herded just like everyone else.

Loss Aversion: Losses Hurt More Than Gains Feel Good

Kahneman and Tversky’s biggest contribution is prospect theory. The core idea: losing $100 feels about two and a half times worse than gaining $100 feels good. They tested this by offering people a coin flip. Heads you win $100, tails you lose $100. Most people refused. To get them to accept, the potential gain had to be around $250. A $250 gain versus a $100 loss. That’s how much more we hate losing.

This creates a specific investing mistake Malkiel calls the “disposition effect.” Investors sell their winners too early and hold their losers too long. Selling a winner feels great. You get to brag about it. Selling a loser means admitting you were wrong. So people sit on bad stocks hoping for a recovery that often never comes.

This is financially backwards. In a taxable account, selling winners triggers capital gains taxes. Selling losers gives you a tax deduction. The rational move is the opposite of what feels natural.

Loss aversion also explains why people don’t save enough for retirement. Putting money into a 401(k) feels like a loss of spending money right now. Even when the employer matches contributions, many employees still refuse to sign up. Richard Thaler and Shlomo Benartzi found a clever fix: have employees commit to saving a portion of future raises. Since the raise hasn’t happened yet, it doesn’t feel like a loss.

Can’t Smart Traders Fix This?

Efficient market believers have a standard response: sure, some investors are irrational, but smart traders will correct any mispricings. If a stock is overvalued, someone will short it. Problem solved.

Malkiel explains why this doesn’t always work. If you shorted Internet stocks in 1999, you were theoretically correct. But the bubble didn’t burst until 2000. In the meantime, prices kept rising and you could have been wiped out. The market can remain irrational longer than you can remain solvent. Hedge funds actually made things worse during the Internet boom. They rode the bubble up instead of fighting it.

The Takeaways

Malkiel pulls four practical lessons from all this.

Don’t follow the herd. When an investment becomes the topic of every dinner party conversation, that’s usually the worst time to buy. Gold in the 1980s. Japanese stocks in the late 1980s. Internet stocks in the late 1990s. Florida condos in the mid-2000s. Every hot investment eventually went cold.

Don’t overtrade. The most active traders in the Barber and Odean study earned 11.4 percent annually while the market returned 17.9 percent. That’s a massive gap, driven entirely by too many transactions.

Sell your losers, not your winners. It feels wrong, but the math is clear. Tax-loss harvesting is one of the few free lunches in investing.

Be skeptical of hot tips and foolproof schemes. Your uncle’s diamond mine tip, the biotech stock at a dollar a share, the fund manager who promises consistent returns. Remember Madoff. He only offered 10 to 12 percent annually, which sounded reasonable. It wasn’t remotely possible without fraud.

Malkiel ends the chapter with a poker analogy. If you sit down at the table and can’t figure out who the sucker is, get up and leave. Because it’s you. The first step to not being the sucker is understanding that your brain is working against you every time you open a brokerage account.

Does any of this mean you can beat the market by being smarter about biases? Some behavioralists think so. Malkiel is skeptical. He’ll dig into that question in the next chapter.

Previous: Risk and Reward: Understanding Beta and CAPM Next: Is the Stock Market Really Efficient? Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5