Nothing like a day when your laptop isn’t working to catch up on some reading. And what better reading than the exciting world of behavioral finance? I guess it takes a certain kind of nut job to find that exciting, but on the other hand I find asparagus delicious, so it’s safe to say I’m strange like that.
So, without further ado, let me present some of the surprising things I read today in Beyond Greed and Fear (an authoritative guide on what truly influences the decision making process in investment).
The link between regret, responsibility and financial advisers
Suppose 3 individuals, with the same amount of money to invest made the following decisions:
- A, who made his own analysis of the market, sold his position in stocks and invested in CDs (certificate of deposit: low returns, low risk)
- B, who always invested in CDs and continued his usual strategy
- C, who followed his financial investor’s advice and traded out of stocks and into CDs
Now, suppose that in the following year the market appreciated by 15% and all three investors who held CD portfolios with low returns are now filled with regret. But who feels the most regret?
You guessed it! A, who had no one else to blame but himself, is the one filled with the most regret. C, on the other hand, does not feel so bad, since he was just following what for him was a conventional strategy. However, in the long term, we tend to regret inaction more than action, so C may feel just as disappointed in a couple of years.
What I find interesting is the case for B. B feels little regret because he can blame the bad investment decision on his adviser. Even more remarkable is that the author would even argue that the shifting of responsibility from C to his adviser is one of the main services for which the adviser gets paid. Conveniently, the investor can attribute gains to his choices and savvy while blaming loses on his financial adviser.
The failure to diversify
No gossip is as tasty as hypocritical behavior and the financial world is filled with such examples. When talking about the failure to diversify, Shefrin mentions an investor (who computes mean-variance efficiency portfolios for a living) who admits to the fact that his retirement plan is based on one single stock, namely Microsoft.
Accordingly, a survey by Lease, Lewellen and Schlarbaum found that investors who held accounts with brokerage firms (those preaching diversification and all) had an average number of stock in a portfolio ranging from (9.4 to 12.1). However, when trading for their own portfolios (in their personal capacity as opposed to representing the brokerage firms), investors had portfolios of 3.41 stocks on average. Why is it that these investors follow procedure and rational portfolio diversification procedures at work, but when they trade for themselves they put all that logic aside?
Even Markovitz himself, the father of portfolio management, admitted to having set up his retirement plan as follows: divide the money equally across all choices the retirement plan offered. No standards deviations, no expected returns, no betas, no nothing.
Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing
Hersh Shefrin, 2000