Fool.com: Behavioral Finance 102 [Fool on the Hill] July 28, 2000

FOOL ON THE HILL: An Investment Opinion
Behavioral Finance 102

The pummeling Nokia took this week demonstrated how irrational investors can become in the face of uncertainty. Ever wonder why mutual fund managers tend to underperform the S&P 500? Evolution has something to do with it, as does overconfidence. In the end, too often when we face imminent danger, we react instinctively rather than rationally. Superior investing returns may be achieved by those who retain the self-awareness to overcome our limitations.

By Bill Mann (TMF Otter)
July 28, 2000

On Wednesday, we discussed the human tendency to be irrational in the face of uncertainty. Well, yesterday we saw an example that could not have demonstrated this any better:

Nokia (NYSE: NOK) Earnings Per Share: Up 77% over previous year
Share Price: Down 27% on 121 million shares traded

For those of you playing the home game, that's nearly $70 billion in market capitalization erased. And that's a share volume of $5 billion on the U.S. exchanges alone. At those levels, the vast majority of the money flow comes from institutions. So, what we witnessed yesterday was not only individual investors, but also mutual fund, pension, and other large money managers rushing for the exit with lemming-like determination. Nokia warned that its product cycles will cause lower earnings and growth for one quarter, and the market responded by trading nearly 3% of the company's entire market cap.

Is this an appropriate level of churn for a company with trailing 12-month profits of $3.3 billion? No. In fact, it is off the charts. But, the average annual turnover for New York Stock Exchange companies is 80% (meaning that 4 out of 5 shares of companies on the NYSE is traded in a year). Were we to eliminate insider positions, this number would exceed 100%. Nasdaq stocks' churn is even higher.

The culprit of this overtrading, as postulated in the first part of this column, is overconfidence, which is at its base an irrational and innate human characteristic. Humans have a need to try to exert control over that which is inherently uncontrollable. We count on the superiority of our knowledge, our rationality, and our ability to process information to help us achieve better-than-average results. And, in the end, our own humanness conspires against us. In the face of unseen danger, we become bold. When we face imminent danger or actualized danger, we react instinctively rather than rationally. In the perception of safety, we tend toward greater risk-taking.

Humans generally lack the cognitive ability to properly measure risks and rewards. In investing, those who have even a slight advantage in recognizing risks and rewards will have a Darwinian advantage that will be amplified over the length of a career.

In some ways, some of the most rational owners are ones who recognize, either actively or passively, that they are unsure of their ability to beat the market. But, a good number of people make a big mistake here by entrusting their capital to an investment manager who, in most cases, is also unable to beat the market, because he or she has the same cognitive irrationality that all humans have. In fact, studying Warren Buffett's investing career, it has been said that his greatest advantage is not one of analysis, but rather his willingness to be anti-social.

Professional money managers fail to beat the S&P 500 at an average rate of 70% per year. In most cases, the ones who do beat the S&P one year regress to the mean the next so that 90% of all professional managers trail the S&P over a 10-year period. These are the people who have more knowledge and more training than the vast majority of investors. And yet, neither the superior knowledge nor the superior experience helps them in the long run. Why is this?

We can point to a few human traits, none of which assist in making rational assessments of risk and reward.

The Comfort of Crowds
To humans, a group offers safety. Professional advisors are judged on their performance in 90-day windows, and underperformance can be treated quite harshly. One interesting tendency due to this is that managers of funds with related objectives will all be holding the same few stocks. There is a bit of self-preservation here that goes beyond the "quality of the company."

Perception is that if a manager holds the Ciscos (Nasdaq: CSCO) or GEs (NYSE: GE) of the world and they drop, the economy can be blamed. Should they, however, show more creativity with their stock-picking, the onus will fall directly on them. The confirmation of going with the crowd is powerfully attractive to institutional and individual shareholders alike. Some believe that these managers tend to rely on the highest profile "hot" companies in the belief that they have less chance of being fired.

Overconfidence
Money managers tend to have this in spades -- you'd almost have to in order to manage billions of dollars of other peoples' money. Further, institutional investors have more information and resources than individuals. If institutional money managers need information about a company, they generally have access to all levels of management. It is often in the area that we have the most knowledge that we also display the most confidence. This overconfidence and the closeness to the market leads managers to overtrade, in the belief that they can beat the market. Not surprisingly, the funds with the highest churn and the lowest returns are largely coextensive.

Unfortunately, despite what those Janus ads tell you, it is impossible to be completely deductive, so we must rely on our incomplete knowledge and our impressions. Unfortunately, we also have the tendency to seek confirming information and neglect information that is counter to our preconceived notions. Anyone who has ever been to a sports game knows this is true -- we see what we want to see. Half a crowd sees a great play, the other sees a flagrant penalty, depending on their perspective.

Dependence on Rationality
Money managers, like humans in general, are more comfortable with phenomena they can explain. Capital markets have advanced rapidly in the last 400 years. To think that our minds have developed the ability to explain and rationalize them at the same speed is fallacious. C. S. First Boston analyst Michael Mauboussin said "We love a story, especially when it links cause to effect." However, in the markets the cause-and-effect story, while satisfying, should be viewed with skepticism. When you hear some business analyst talking about "the market" reacting to this or that, understand that, although such explanations are nice, there is no such thing as a simple stimulus-response in the capital markets.

Dependence on Past Experience, or Feedback Loops
Investors are consistently trying to catch the pulse of the market, none more so than professionals. Thus forms the stuff of feedback loops, in which recent past experience is overvalued even if it is contrary to the longer-term trends. How many investors shook with fright when October rolled around last year, thinking that it was the most likely month for a crash? Didn't happen. In fact, October was the beginning of a fairly astounding run in several market sectors.

How many investors who started in the past five years -- with consecutive returns in the S&P 500 of 37%, 23%, 33%, 28%, and 21% -- are convinced that these types of returns are the norm? Humans try to apply knowledge and experience of past events to the future, when these outsized returns are historically extraordinary. Moreover, our desire to assign logic to these events precludes us from making a rational assessment of the risks such returns can bring about.

Given the above, the fact that so many money managers trail the S&P 500 should not be surprising. People holding mutual funds are asking other humans to do something that they are simply not designed to do. Superior investing returns may be achieved by those who retain the self-awareness to overcome our limitations. Investor psychology is a powerful force. It is also generally to our detriment to get caught up in it.

The Foolish investor must be willing to be critical when times are good, opportunistic when times are bad, and aware enough to know that, even though index funds are less exciting, they are a perfectly valid place to rationally invest in the market -- either as a comprehensive strategy or as a part of one containing index shares and a few common stocks.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:

  • Boring Portfolio: "The Perils of Investor Overconfidence"
  • Michael Mauboussin's Frontiers of Finance
  • Berkshire Hathaway Shareholder Letters