The following is an excerpt from the letter we wrote to clients in July 2013 and provides a worthy lesson in behavioral investment.
Peter Bernstein in Against the Gods states that the evidence of investor behavior “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways [they] arrive at decisions and choices when faced with uncertainty.” One bias is the simple tendency of investors to be influenced by recent events and the propensity to respond to short-term events, even if the investment time horizon is long. This bias has been shown to influence people regardless of their investment experience, occupation, net worth, education, or age.
A non-financial example of this behavioral flaw may be useful. Carl Richards of the New York Times recently highlighted a 2005 academic study focused on the decision making of penalty kicks in soccer. Because of the speed at which the ball is kicked in high level soccer and the short distance of a penalty kick (12 yards), goalies have almost no time to react and must inevitably make the decision to dive left or right in advance of the kick itself. The findings are an instructive example of human tendency. Goalkeepers elected to dive either left or right 93.7% of the time and remained in place only 6.3% percent of the time. The research further demonstrated that the optimal action (by a wide margin) would be inaction. That is, a goalkeeper would have nearly doubled his save rate on any single penalty kick by merely staying in place.
Why do goalkeepers continuously make the mistake of diving left or right when the far more optimal strategy is staying in place? Because diving is the norm, a goalkeeper who dives to one side and misses the save is less embarrassed than a goalkeeper who stands in place and misses the save. Carl Richards explains, “Everyone is expecting action. Every other goalkeeper in the world dives to a side of the goal. Just standing there would be embarrassing.” So despite the huge incentives involved, goalkeepers make the suboptimal decision.
This same illogical action bias, as psychologists define it, is also demonstrated in investing. Investors are more likely to sell investments after bad recent performance or buy investments after good recent performance, and there is a pronounced tendency for investors to trade after recent losses[i]. Humans just feel less regret (or embarrassment) if they take action (trade, dive, etc.) and lose than if they do nothing and still lose. Resultantly, there is a bias to take action that can work against them.
Tremendous empirical evidence demonstrates that investor timing decisions result in significant loss of capital. The most current version of the popular Dalbar Investor Behavior Study concludes that individual investors using equity mutual funds have cost themselves 3.96% per year over the past 20 years as the result of market timing. In dollar terms, this translates to an action bias cost of $2.55 million for a $1 million initial investment. As in soccer, the action bias is clearly suboptimal for investors.
The letter concludes with some instructive lessons and finishes with this important advice: When it comes to investing, activity is not positively correlated with success. Although human minds foolishly compel us to action, patient investors tend to be the most successful. Warren Buffett famously describes investing as the process of “transferring wealth from the impatient to the patient”.
[i] Zeelenberg et al (2002), “Investigating the Appraisal Patterns of Regret and Disappointment”