Blogs | December 19, 2011

My top five lessons of 2011

2011 has been a fine year for “proper economics” – the rigorous and, yes, scientific study of behaviour.

It’s given us some great research and fascinating insight. Here are five of my favourite pieces about the tips, tricks and traps people face when managing money.

1. Beware illusory knowledge: The behaviour of individual investors by Brad Barber and Terrance Odean. The two California-based economists survey evidence from around the world on individuals’ stock market investment performance. They find that it is “poor”, and give some reasons for this.
One is overconfidence; people think they know more than they do and trade too often, which incurs high dealing charges without better returns.
Another is illusory knowledge. Investors tend to buy stocks in businesses they think they know – either because they are local or because they work in the same industry. But this doesn’t pay off.
A further error is what economists call the disposition effect – investors sell good performing stocks too soon and hold onto losing stocks. Instead of exploiting momentum, individuals make themselves victims of it.

2. Profits can be “addictive”: Fear, greed and financial crises: a cognitive neurosciences perspective by Andrew Lo. If Barber and Odean show that we often go wrong, Professor Lo shows why. He points out that profits and losses are not merely mirror images of each other, but are in fact processed by entirely different parts of the brain. This helps explain why we sometimes treat them so differently.
Faced with losses, we gamble in an effort to break even; this is why we hold onto losing stocks and why rogue traders sometimes rack up colossal losses.
Faced with profits, though, we are more cautious. But not always. Professor Lo describes how regular profits work a little like cocaine; both release dopamine into the brain. This can give people a buzz that causes them to become addicted to gambling. And it can also cause asset price bubbles, as previous gains lead people to buy more.

3. Which investors follow the “herd” more often?: What drives the herding behaviour of individual investors? by Maxime Merli and Tristan Roger. Another cause of bubbles is that investors tend to herd; we buy what others buy, and sell what they sell. This study of over 87,000 retail equity investors showed how common this is. The authors show that an individual is about one-fifth more likely to buy a particular stock in a month if other retail investors are also buyers.
Some investors, however, herd more than others. Merli and Roger show that people who trade only infrequently, or hold very few stocks, are more likely to do so than wealthier or more sophisticated investors. So too are investors who have recently lost money. This suggests that herd behaviour arises from a belief that one doesn't know what one is doing.

4. Wheat prices, wishful thinking and shares: Wishful thinking by Guy Mayraz. There’s another reason why we go wrong, as a nice experiment by this Oxford-based economist showed. He got subjects to guess the future price of wheat, paying them according to the accuracy of their guesses. But he split them randomly into two groups. One – “farmers” – were paid more if the price turned out to be high. The other – “bakers” – were paid more if the price were low. And he found that “farmers” made significantly higher guesses than “bakers.” And this remained the case even if he increased the payment for accurate guesses.
This shows just how easy it is for wishful thinking to arise. And this has obvious investment implications. It means we might expect shares to outperform simply because we happen to hold them – which, again, encourages us to hold onto losing shares.

5. Lessons for the long-term: Investing for the long-run by Andrew Ang and Knut Kjaer. Lots of people like to think of themselves as long-term investors. But how should such investors behave? Ang and Kjaer set out some principles:
- Be contrarian. Rebalance your portfolio regularly – say, every year – with a view to selling good performing assets and buying poorly performing ones. They key word here is “asset”, rather than individual stocks. The study suggests this rule will help long-term investors buy shares when they are cheapest, which is when short-term investors are nervous about them.
- Exploit equity factors that pay-off in the long-run. This means holding “value” stocks rather than growth ones, and taking advantage of momentum. It also means being wary of good-performing fund managers, as their out-performance tends to be temporary.
- Consider buying illiquid assets (such as private equity or alternative assets such as wine) as long as you can be reasonably sure they are under-priced. The point is that short-term investors hate assets which they cannot sell quickly. This should mean they are cheap for long-term investors who can afford to take them on.

Helping us avoid errors
These papers might seem very different from each other. There are two surveys, an analytical piece, a study of a large data set and – what is increasingly common – an experiment. But, in fact, they have something in common. They all analyse how our investment choices can go wrong, and thus help us avoid errors. Herein, I think, lies the true value of economics to investors. It cannot make us rich by predicting the future. But it can help us avoid some of the more egregious ways of getting poorer.


Chris Dillow
Chris Dillow

Investors Chronicle writer and economist