Lew Sanders, the founder and CIO of Sanders Capital Management gave a speech at the Columbia Business School detailing his work in behavioral finance and investing. It is a great expose of our innate human biases, which directly interfere with our rationality and ability to make sound investment decisions.
Here are a few of Sander’s key points:
A Preference for Certainty:
Unsurprisingly, people have a strong preference for certainty. In investing, this manifests itself in investors having a preference for financial assets where the outcome appears to be certain. This leads the average household to hold a very high percentage of its net worth in assets they view as having certain outcomes, despite their lower long-term returns (savings accounts, CDs, municipal and Treasury bonds). Conversely, those assets perceived to have a higher degree of uncertainty (stocks, high yield bonds, etc) are underrepresented in the typical household, despite their history of higher long-term returns. Two example help to illustrate this.
Choice A: You have a 33% chance of getting $2,500, a 66% chance of getting $2,400, and a 1% chance of getting nothing.
Choice B: You have a 100% chance of getting $2,400.
The expected value of Choice A is $2,409, $9 higher than the $2,400 expected value of Choice B. Despite this, people choose the certainty of Choice B 82% of the time. We feel the small expected value gain was simply not enough compensation for the wide range of outcomes in Choice A. The preference for certainty at work.
Gambling Bias:
When dealing with low probability scenarios, people tend to irrationally gamble.
Choice A: You have a 1% chance of getting $6,000 and a 99% chance of getting $0.
Choice B: You have a 2% chance of getting $3,000 and a 98% chance of getting $0.
Despite both choices having the same expected value ($60), people chose Choice A 70% of the time. Why? When people have a very small chance of winning a large amount, they will tend to choose the lowest odds with the highest payout. The popularity of lotteries, with their extremely poor expected value, is a classic example.
Loss Aversion Bias:
People react irrationally when dealing with investment losses.
Example 1:
Choice A: You have an 80% chance of getting $4,000, and a 20% chance of getting $0, with an expected value of $3,200.
Choice B: You have a 100% chance of getting $3,000 ($3,000 expected value).
Despite the fairly wide expected value advantage of Choice A ($200), people choose Choice B 80% of the time.
This shows certainty bias, which we have already discussed. What is interesting, however, is what happens when we use the same numbers from Example 1, but make the numbers negative:
Example 2:
Choice A: You have an 80% chance of losing $4,000, and a 20% chance of losing $0, with an expected value of -$3,200.
Choice B: You have a 100% chance of losing $3,000 (expected value -$3,000).
In this case, despite Choice A having a wide expected value disadvantage (-$200), people now choose Choice A an overwhelming 92% of the time. Investors gamble to avoid a certain loss.
Conclusion
We have all heard the old quip: “We have met the enemy, and he is us.” This is never more true that in the world of personal finances and investment. From certainty bias, to a bias to gamble, to loss aversion, investors need to build in safeguards.It is critical to be aware of how our innate personal psychology works to our disadvantage, and work with an advisor who can help you combat these tendencies which tend to inhibit long-term investment success for so many.