Aspects of Investor Psychology (Part I)

Since we were forced to stay at home because of the storm, I decided to pull out a paper I printed out sometime ago and but didn’t have time to read. The paper, Aspects of Investor Psychology, by D. Kahneman and M. Riepe, is not new (published in 1998 in Journal Portfolio Management), but it offers some insights on the decision-making of investors. Though the target readers of this paper are financial advisors, I think everybody can benefit from what the paper has to offer, not just financial advisors.

The paper begins with a statement that

 

… financial advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that related to making investment decisions: their occasionally faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, the limits of their ability to accept advice and to live with the decisions they make.

 

As an investor, we tend to make decisions based on intuitions and biased judgments, which many times were proven to be wrong, without a thorough analysis of all the facts and possible consequences before a decision was made. To show how investor’s decision making ability is affected by intuitions, the paper asks a series of questions and provides recommendations for a sound decision.

Here are the questions:

Question 1: What’s your best estimate of the value of the Dow Jones one month from today? Next pick a high value such that you are 99% sure that the Dow Jones a month from today well be lower than that value. Now pick a low value such that you are 99% sure that the Dow Jones a month from today well be higher than that value.

The first question exposes the overconfidence phenomenon in decision making. If you carry out as instructed for the above question, it makes you 98% sure that the Down Jones will be in the ranges you picked one month from today and you have 1% of high surprises (the real value is higher than your high estimate) and 1% of low surprises (the real value is lower than your low estimate). If the Dow Jones value indeed falls inside your estimated range one month from today, you are well-calibrated in your judgments of probability. However, for many people, there are too many surprises. In other words, investors are often overconfident about their abilities to make unbiased judgments.

And recommendations for overconfidence:

 

  • Keep track of instances of your own overconfidence;
  • Be mindful of your propensity for overconfidence when making statements to clients. Bold statements may help attract clients, but failure to live up to them will come back to haunt the advisor;
  • Make clients aware of the uncertainty involved with investment decisions;
  • Do not let clients project their own overconfidence onto you. If you do, you will create an unreasonably high standard of performance that will lead to short-lived client relationships.

Though the above recommendations are for advisors, they are also applicable to investors, in my opinion.

 

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