By Travis Gallton
The Daily Record Newswire
Throughout the past decade, academics and financial consultants have preached to investors that markets are efficient and that buy-and-hold strategies trump all.
As logic would tell you, however, the truth is that humans are irrational, and make judgments based on both fear and greed. That fear and greed mentality has led to extreme market volatility, which has seen typical buy-and-hold strategies lag behind actively managed portfolios.
Departments of finance in universities throughout the country for years have emphasized the different forms of the efficient market hypothesis. If you were to poll those actually practicing in the industry, however, a majority would strongly disagree.
The reason? The psychology of investors’ behaviors and human emotions lead them to be biased on the true intrinsic value of a security.
In turn, emotion and behavioral drivers often cause investors to both over- and undervalue securities based on perceptions rather than objectivity. The significance of the phenomenon often is underplayed by academics and consultants, but behavioral finance tells us much about how and what investors actually think.
As a brief overview, behavioral finance is a field that combines understanding cognitive psychological theory with investors making irrational financial decisions. When investors allow bias to influence their decisionmaking there may be no economic or fundamental reason for their investment actions. To gain a better understanding, I’ll examine a few key biases that affect investors’ perceptions:
Confirmation bias
Confirmation bias occurs when investors look for information to support their original preconceived idea rather than information that may contradict it, thereby compiling an incomplete picture of the overall situation.
Hindsight bias
Hindsight bias is the inclination that some events that occurred were more predictable than before they took place. A great example is the subprime mortgage crisis: Had the bubble been obvious at the time, it never would have escalated to the scale it did.
Herd mentality
Herd mentality is another bias, wherein retail investors tend to chase “hot” sectors. Those individuals feel pressured to conform to a group. What are the chances a large group could be wrong?
Prospect theory
Prospect theory looks at how investors react differently to cases of gains and losses rather than assets’ final market value. In other words, investors are loss averse — more willing to avoid potential losses than to improve their positions.
Given the biases presented, logical questions arise: How do those biases affect you as an investor? How can you protect yourself against their potentially negative effects on your portfolio?
The simple answer to the first question is that the biases create inefficiencies within the marketplace because investors’ perceptions of value become skewed. As a result, the overall market will tend to drift away from its fundamental value and, as stated previously, will tend to be either over- or undervalued at any given time.
To answer the second question, it can prove very difficult to cost effectively and efficiently capitalize on the inefficiencies created by the emotion of other investors. That being said, the best way for an investor to capitalize on such inefficiencies is to hire an active investment manager who can digest information and stock price movements quickly to exploit any inefficiencies.
Empirical evidence has shown that active managers repeatedly outperform their benchmarks for extended periods by capitalizing on inefficiencies for their clients.
All investors should beware that fear and greed can severely influence their investment decisions. Knowing that key lesson, investors should understand psychology plays a key role in human decisionmaking. With market participants having distorted perceptions of what is “efficient,” it is best to abate such biases by entrusting investment decisions to an active money manager with a proven track record.
Travis Gallton is an analyst/portfolio manager for Karpus Investment Management. He can be contacted at (585) 586-4680.
