[ARCHIVES] Michael Mauboussin: Pitfalls to Avoid

[ARCHIVES] Michael Mauboussin: Pitfalls to Avoid
Darien Library Meet the Author: Michael Mauboussin (CC BY-ND 2.0) via <a href="https://www.flickr.com/photos/darienlibrary/4068740879" target="_blank">Flickr</a>

Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.

From 2001 Michael Mauboussin: Pitfalls to Avoid

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Michael Mauboussin: Pitfalls to Avoid

Warren Buffett says that smarts and talent are like a motor’s horsepower, but that the motor’s output depends on rationality. “A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output,” he said. “It’s way better to have a 200-horsepower motor and get it all into output.”1 Even bright investors with an intelligent stock-picking approach don’t reach their potential if they fail to make disciplined decisions. By exposing the major pitfalls to avoid, this chapter will help you make your output rise toward your horsepower.

Classical economic theory assumes that all people have the same preferences, perfect knowledge of all alternatives, and understand the consequences of their decisions. In short, people behave rationally. No one really believes that this idyllic state exists. In fact, ample empirical research and anecdotal evidence show that people aren’t perfectly rational. This gap between theory and practice has spawned a new field called behavioral finance.2 Researchers in this field seek to bridge the gap between classical economics and psychology to explain how and why people, and markets, behave.

Michael Mauboussin: Behavioral finance raises a couple of key issues for investors

Behavioral finance raises a couple of key issues for investors. The first is whether or not it is possible to exploit irrational behavior when it occurs. If we know when people are acting irrationally, can we take advantage of the resulting value-toprice gaps? The second is how to avoid making bad decisions as an investor. The goal is to close the gap between how we actually make decisions and how we should make decisions. Minimizing mistakes helps us achieve superior returns. Behavioral finance’s fundamental lessons are a valuable complement to the expectations investing process. We can analyze investor behavior either at a collective or an individual level.

Collective behavior deals with the potentially irrational actions of groups, and is typically associated with “excessive” market swings. Evidence includes investor herding and price bubbles. Herding is when a large group of investors make the same choice based on the observations of others, independent of their own knowledge. This massive social imitation can occasionally lead to inefficiencies—i.e., discernable gaps between value and price. A price bubble, often the result of herding, is the part of an asset price movement that can’t be explained by fundamentals.

These collective behavior phenomena are interesting to the extent that they create profitable expectations opportunities for individual stocks. But taking advantage of collective irrationality, either for a specific stock or for the market as a whole, is difficult. Since most humans have a strong urge to be part of the crowd, acting independently is a tough assignment. Furthermore, the crowd is often right. So being a contrarian for its own sake is an unlikely path to investment success.

Analysis of individual behavior focuses on the fact that investors consistently fall into “psychological traps.” There are two main sources for these traps. The first is behavior that does not conform to sound economic theory. This source is formally articulated in prospect theory, developed by Daniel Kahneman and Amos Tversky, which identifies economic behaviors that are inconsistent with rational decision-making.

For example, people act in a risk-averse way when making choices between risky outcomes, conflicting with the “rational” behavior predicted by expected utility theory. Suppose you had a choice between (1) accepting a sure loss of $750 or (2) taking a chance where there is a 75% chance of losing $1,000 and a 25% chance of losing nothing. Both choices have an expected loss of $750, but most people pick the latter because the uncertain choice holds out the hope that they won’t have to lose. As we will see, this risk aversion can influence investor buy and sell decisions.

Heuristic biases are a second cause of psychological traps. Investors use rules of-thumb, or heuristics, to help simplify their lives. Heuristics are useful because they reduce the information demands of decision-making. However, they also lead to biases that can undermine the quality of our decisions. Many of these biases exist because of how humans are hardwired to think.

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