In the beginning of 2016, I experienced my first market panic. The S&P had its worst beginning of the year in history, provoking fear among investors as selling begat selling. As the market tanked at the year's start, phone calls and emails from panicked investors filled our days and inboxes. But, with each passing day it became less clear what investors wanted from these conversations: were they simply after reassurance or did they truly want us to head for the exits?
It reminded me of something I read in the 2013 Berkshire Hathaway annual letter, “Owners of stocks . . . too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well.” I was witnessing this firsthand.
Working at LMM, I have been immersed in the field of behavioral finance, which studies investor behavior. These phone calls brought to light how easy it is to fall into the traps of behavioral biases, especially during periods of market turmoil. Many of the behavioral biases that lurk in the background during good times took center stage at the peak of the panic in February. The behavior I witnessed earlier this year made behavioral biases tangible for me.
Herding is one of the most common human tendencies. While investors claim to know that it does not provide superior returns, investors frequently give into this behavior. Dr. Greg Berns, of Emory University, examined social conformity using functional magnetic resonance imaging (fMRI). The results of the study showed that test subjects who made independent judgments that conflicted with the group exhibited heightened activity in the right amygdala – the part of the brain which processes emotions. This implies that going against the crowd induces emotional stress. For money managers, this stress is intensified by TV stations, radio stations, compliance and risk departments, sales departments and investors calling your judgment into question when it conflicts with consensus.
People react more strongly to negative news than they do to positive news. In psychology, this is known as negativity bias. In markets, negativity bias is exemplified through loss aversion bias, in which people tend to be more sensitive to decreases in wealth than to increases. According to Tversky and Kahneman (1992), losses are weighted about twice as strongly as gains. This is easily seen in the decline in the ownership of equities since the financial crisis. Since 2007, there has been $2T of outflows from stocks into bonds1. This is even more astounding when you consider that during the financial crisis (10/09/07-03/09/09), the market saw a cumulative decline of 55% compared to the 255% cumulative return the market has seen since the crisis (03/09/09-05/11/16). During that same post-crisis time period, the BofA Corporate Bond Index had a cumulative return of 78% while the BofA Treasury Index had a cumulative return of only 26%.
Investors’ loss aversion today is further exacerbated by availability bias, in which people estimate the probability of a particular event occurring based on how easily the outcome comes to mind. The 2008 Financial Crisis is still present in investors’ minds, and the ability to easily recall this event causes people to overestimate the likelihood of another crisis occurring. Bill explored this idea in his post A Silver Lining in the Dark Cloud of Volatility. According to Empirical Research Partners, from 2008-2015 institutional investors have placed the probability of a market crash in the next six months at an average of 22%, up over a third from the average 16% seen in pre-crisis times. These probabilities are an order of magnitude larger than the 1% probability implied by the historical frequency of such events.
Availability Bias also intensifies the “dumb money effect”, which describes how investors buy the market after recent periods of high performance but sell after recent periods of low performance – which is exactly the opposite of what they should do. According to Empirical Research Partners, between 2007 and 2010, US millionaires decreased their ownership of equities by roughly 11%. They subsequently increased their ownership by 5% between 2010 and 2013 (after the market had seen an 80% rebound).
In early 2016, I was able to see behavioral biases in action. By studying and recognizing these behavioral biases, we believe we can lessen the impact of behavioral pitfalls on our results and profit from the opportunities they present when exhibited by others.
1Source: Fundstrat Global Advisors
The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.
©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.