Monday, October 24, 2016

We Are Not Always So Rational, Part 3

Montparnasse derailment, 1895. Source: Wikipedia

In the previous 2 posts, we discussed the common behavioral biases that we suffer and where they originate from. In this third post, we discuss the impact of our biases: on ourselves, our portfolios and on the markets.

Impact on ourselves

The financial markets affect all investors’ mental health, at least to some degree.

Even the most conservative, long-term oriented investors felt some shock during the 1987 ‘Black Monday’ crash, 2008 financial crises and 2010 flash crash. On the other end of the spectrum, there are the aggressive types that treat the markets like a casino. It is this group that is particularly damaging their mental well-being.

Aggressive traders are ones that routinely do one or more of the following:
  • Watch every tick of the market and binge on financial media
  • Trade based on emotion without a process, or use a highly complex process
  • Take concentrated and/or leveraged positions in volatile securities (eg. micro-cap stocks)
  • Over-trade / day-trade

Engaging in these activities chronically can lead to addiction, stress, anxiety and even depression. It cannot be overstated how bad stress is for us. How can we prove there is a definitive link between money and mental health issues?

Source: Scott Camazine—Getty Images

There has been extensive scientific research done on how the brain is affected by money. There’s even an entire discipline devoted to it: Neuroeconomics. Studies from the past two decades have revealed that there is a whole lot happening in our brains when money comes up.

In 1997, a study performed brain scans on 12 people that played a game in which they could win or lose money. What they found was that players who were about to make money had increased neural activity in their nucleus accumbens – the region of the brain tied to reward, pleasure, motivation and addiction. These scan images were compared to those of addicts who were high on cocaine. Remarkably, the scans were nearly identical.

In one 2003 study, test subjects were paired with complete strangers. Each pair was given a sum of money and asked to split it. One person would act as the “proposer” while the other as the “responder.” If the pair cannot agree on a split, then neither walks away with cash. The study found that the responders rejected over half the unfair offers (which is irrational since something is better than nothing). But more interestingly, the study found these unfair offers activated a part of the brain in the responders associated with anxiety, pain and hunger.

In 2005, a study was done at Stanford University using Functional Magnetic Resonance Imaging (fMRI). Brain activity of participants was monitored as they chose between stocks and bonds given limited performance info of each. The researchers found they could predict whether a participant would choose to buy a riskier security, like a stock, or a less risky one, like a bond, just by scanning their brains. The subjects who had naturally elevated stimulation of their nucleus accumbens would most likely buy the stock.


Impact on our portfolios

"When it comes to investing, you are your own worst enemy." – Barry Ritholtz

source: Carl Richards at

Not only do biases cause the average investor to suffer health consequences, they also cause serious financial consequences. Our individual biases cause us to make all sorts of portfolio mistakes:
  • Poor allocations: holding concentrated positions in a few stocks or holding too much cash 
  • Poor timing: Holding losers too long, selling winners too early
  • Frequent trading: getting too caught up in day-day noise, falsely believing you can outsmart the market in the short term, trying to irrationally climb out of a loss

Over the 20 year period ending Dec 2008, the folks at Dalbar show us exactly how much damage the average equity investor did to their portfolios: 

Impact on markets

We see that our irrationality in the markets hurts us mentally and financially. Interesting things happen when you look at the behaviour of all individuals as a group.

Each individual investor may make different mistakes (due to their unique biases, genetics, experiences, knowledge, etc.). They may be more loss-averse or suffer greater overconfidence bias than their neighbour. Occasionally, their biases will even cause them to get lucky. However, it turns out that as a group we are extremely consistent at being wrong.

The chart below shows the average individual’s asset allocation between 1988-2010. The average person had a record high allocation to stocks in Jan 2000 (the peak of the tech bubble) and record low allocation to stocks in March 2009 (the exact month the markets bottomed after the 2008 financial crises).  

We can take this one step further.

The chart below shows the average household’s % allocation to equities (blue) and the subsequent 10 year return for the S&P500 (black). This chart is often dubbed the “single best stock market predictor” because of how accurately current investor allocation to stocks can predict future 10-year returns of stocks.

Source: MarketWatch and Ned Davis Research

Note that the scale for the S&P 500 is inverted. Basically, when everyone is in love with stocks, future stock returns are low (and vice versa).

Thus, the collective biases of all market participants cause markets to deviate from perfectly efficient. The momentum anomaly which I discuss often on this blog is partly explained by two behavorial biases: regret aversion ("herding effect") and availability bias ("recency effect"). Other factors are explored in the first post on this blog: Philosophy of Momentum.

In theory, investor sentiment can directly be used to outperform the market. Contrarian investors buy when the herd is bearish and sell when the herd is bullish. But how is sentiment measured? The main methods include: surveys (eg. AAII), money flows, portfolio allocations and options activity (eg. put/call ratios). There are a few research outfits such as and Ned Davis that make a living off selling sentiment research.

However, sentiment trading suffers the same problem as value investing: something that is hated can become even more hated.  A great recent example of this is commodity stocks, which have repeatedly trended lower since 2011 despite breaking all sorts of sentiment records as early as 2013. John Maynard Keynes famously said: “The market can remain irrational longer than you can remain solvent.

Another point I want to make clear is that sentiment is but one factor that drives markets and for the short-term. There are other factors (such as the business cycle, institutional buying/selling, central bank actions) that also influence markets in the short-term. Over the long-term (eg. 10 years), markets have been observed to respect valuations and mean-revert (eg. the current Shiller P/E ratio is a rough indicator of future 10-year stock returns).

Trend following (and momentum) is a much better approach* at outperforming the market. It aligns itself with the market’s trend, which is the collective result of several forces (sentiment being one of them). *It is important to note that this approach must be simple, systematic, evidence-based, robust and of course, forecast & bias free. GEM is one such approach.

To summarize:

Actively investing solely on your cognitive & emotional biases will result in drastically underperforming the broad market and at a cost to your health. The collective irrationality of individuals (among other factors) leads to markets being less than efficient. By being cognizant of this, we can take a trend following approach to outperform the broad market while simultaneously reducing our stress & anxiety.

I will need to add one more post to this series. In part 4, we will look at techniques that will help reduce the impact our emotions have on our investing to ensure we stick to our plan. Stay tuned.


  1. I agree that matching the strategy to the person can lead to less emotional investing. Also, I have found that strenuous exercise six days per week significantly reduces the effect of emotions on my investing.

    Nick de Peyster

    1. Nick - you are 2 steps ahead of me. These are all points I'll be discussing in the next post.


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