This need not result in bubbles, of course. As long as there are more level-headed investors that can identify when others are biased and arbitrage their irrationality away, the resulting stock prices may be completely reasonable. Problems occur when the irrationality becomes systematic – common to a large enough swath of the market that it dominates those trying to arbitrage it away. This is the basis for one underlying theory of behavioral finance: The market will get things right so long as investors are rational and/or any irrational investors cannot affect prices. The fact is, though, that these two conditions are often not met.
The overconfident investor
The most dominant of all biases is overconfidence. 90% of drivers think they are safer on the road than others. A majority of people believe they have above average sense of humor. People want to believe they are skilled or have desirable personality traits, even when it is not the case. The individual investor is no different. This person needs to believe that he or she is better than most investors to justify his or her decision making.
What is more, when investors see their investing decisions proven successful, their confidence only gets stronger. This is confirmation bias at work. Investors will interpret lucky outcomes as a result of skill because after all, they hold the belief that they are skilled and the outcome confirms this belief. When prices are rising as a result of investor optimism, the tendency to attribute lucky outcomes to skill only grows stronger. Then, when optimism runs wild and affects our estimation of the future it becomes nearly impossible to control without careful and deliberate effort.
The keys to mastering the behaviors of the market
In 1999, Richard Thaler, the godfather of behavioral finance, published a paper entitled “The End of Behavioral Finance.” The implication was that the study of investor behavior is not a sub field of finance or something to be studied in isolation, but finance itself. To study markets without studying the behavior of market participants is to ignore the most important component. But can we directly benefit from understanding what makes investors tick? The answer to that question is not straightforward.
There is no single trading strategy that has arisen from the study of investor behavior – no “endowment effect” strategy or “disposition effect” strategy that predicts future results. Rather, the biases of investors are far too intertwined to be isolated and exploited. Investors may be systematically overconfident at times, but simultaneously the victims of other biases that negate its impact.
That makes control of these biases essential to investment success. This can happen in two ways. First, the investor must be cognizant of his or her own biases and do everything possible to keep them from affecting decision making. This is difficult but can be achieved by taking a programmatic or quantitative approach to stock selection. Second, the investor must be poised to take advantage of stock prices that have been affected by the biases of others. As Warren Buffett said, “Be fearful when others are greedy, and greedy when others are fearful.”