6 minute read

The behavioral biases of investors offer opportunities to outperform so long as you avoid falling into the same traps, argues Giles Parkinson.*

Half a century after academics first argued it was futile to search for undervalued stocks because prices always incorporate and reflect all relevant information, the “efficient market hypothesis” (EMH) remains a cornerstone of modern financial theory.

However, few ideas have proven as contentious. While there has been no shortage of academic studies supporting the view that it is impossible to “beat the market”, many others disagree. For instance, in a 1984 article entitled “The Superinvestors of Graham-and-Doddsville”, which was based on a speech he gave in honor of the 50th anniversary of the publication of Benjamin Graham and David Dodd’s seminal book Security Analysis, Warren Buffett famously challenged the idea that equity markets are efficient.[1] The article showed how nine investment funds – which were managed by Graham's alumni with little in common other than the pursuit of “value investing” – had generated long-term returns above the market. According to the EMH, that should have been statistically impossible.

In fact, the intellectual dominance of the EMH had begun to be challenged a decade earlier. Its shortcomings were highlighted with the work of cognitive psychologists Daniel Kahneman and Amos Tversky, who published a series of articles in the 1970s that in turn heralded the discipline of behavioral finance.[2] They sought to combine behavioral and cognitive psychological theory with conventional economics and finance in an attempt to explain the irrational ways in which financial market participants
can apparently behave.

From a theoretical perspective, one of the main critiques of the EMH stems from its assumption that people always act rationally. In reality, there are many instances where emotion and psychology influence our decisions and cause people to behave in unpredictable or irrational ways, forcing stock prices to seriously deviate from “fair value.” How else can the crash of October 1987, when the US stock market plunged more than 20% in a single day for little apparent reason, be explained?

Devotees of behavioral finance argue everyone in the investment chain can be influenced by emotional and behavioral biases and heuristics – decision-making short-cuts that rely upon stereotypes, past experiences or easy ways of calculating numbers to provide an approximate answer. If they are right, then from an equity investor’s perspective it is important to be aware of some of the more important pitfalls we may encounter and devise mechanisms to overcome them.


One of the biggest dangers comes from human overconfidence. The “Lake Wobegon effect” was coined by US psychology professor David Myers to refer to the tendency to irrationally overestimate one's capabilities. The phrase pays homage to the fictional town created by author Garrison Keillor, where "all the women are strong, all the men are good looking, and all the children are above average”.

Worryingly, numerous studies have found experts tend to suffer more from this flaw than lay people, and fund managers appear no exception. For instance, in a 2006 paper entitled “Behaving Badly”, Dresdner Kleinwort Wasserstein analyst James Montier found that 74% of 300 fund managers surveyed thought they were above average at their jobs, while the majority of the remainder thought they were average.[3]

One of the consequences of this overconfidence is that most fund managers and analysts continue to place forecasting and detailed financial modelling at the heart of their investment process, despite repeated studies that show they are actually not very good at predicting the future.

Among the lessons to draw from this is that there is little sense in relying on macroeconomic forecasts when attempting to evaluate a company’s worth. Modelling how fast revenues will grow if inflation is 2.1% as opposed to 1.8% is missing the point. By contrast, gauging the chances of a company maintaining its pricing power in the future is crucial.

John Maynard Keynes famously remarked it is “better to be roughly right than precisely wrong”. The lesson for investors is that it is necessary to be comfortable with uncertainty. The seductive certainty
provided by a three-stage discounted cash flow analysis is of questionable merit when attempting to ascertain a company’s value. It would be far more beneficial to try to assess the possibility of the firm growing fivefold, for example, over the next decade.

For this reason, we do not use share price targets. But just because you cannot measure a company’s intrinsic value with precision does not mean you should not think about it. As American sociologist William Bruce Cameron observed: “Not everything that counts can be counted, and not everything that can be counted counts”. Instead, I like to think in grey terms of whether a share looks “cheap”, “expensive”, or “fair”. Companies’ values, and hence the relative attractiveness of different investment opportunities across the market and within a portfolio, constantly evolve.


Another cognitive trap investors commonly fall in to is anchoring, which refers to a tendency to attach or “anchor” our thoughts to a reference point, even if that reference point is neither logical nor relevant. For instance, the price you paid for a particular share of stock ought to count for nothing. The only thing that matters is the prospective return that stock offers.

Similarly, in the event the market has suddenly risen, there will be a temptation to hold back from investing new cash that has come into the fund in the hope shares will fall back to their previous levels.

As a result, you may end up ignoring the fact there are good reasons for the market to have gone up and be left behind. It is important to invest on the basis of today’s prices and, unless you have demonstrated an affinity for it, refrain from attempts at market timing.

For these reasons, it is unwise to keep a close eye on the book cost of individual investments within a portfolio. This also helps to mitigate “loss aversion”, another bias whereby we feel losses more acutely than gains, and may be reluctant to realize a loss even when the investment thesis is broken.

Herd behavior

One of the most infamous financial events in recent memory was the bursting of the so-called dot.com bubble in early 2000. Many put the bubble down to another human attribute: herd behavior, where individuals are disposed to mimic the actions of a larger group.

When it comes to investing, one of the dangers posed by herd behavior is that it can result in fund managers adopting similar positions to one another for fear of underperforming the peer group. As Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Benchmarking is one manifestation of this. Tasked with outperforming the FTSE 100, the tendency is to make an “underweight” or “overweight” decision against all hundred stocks. The result is a portfolio that minimizes differences with an index because to deviate from this benchmark becomes the definition of risk. 

A more sensible way to invest is to start from what stocks you want to own regardless of their size, country of listing, or sector classification, and designing the portfolio to achieve an outcome. This also
helps to overcome “home bias”, whereby investors have an oversized allocation to equities in their domestic market and are irrationally reluctant to look elsewhere.

Confirmation bias

Much as people may say they carefully gather and evaluate information before making decisions, the reality can be very different. During last year’s US presidential election when, amid a flurry of what became known as “fake news” stories, segments of the electorate demonstrated a tendency to react uncritically to information that fit a desired narrative. When observed among professional investors, the same pattern of behavior is known as confirmation bias.

For instance, it is a widely held view within the asset management industry that meeting a company’s senior executives can add significant value to the investment process. I have mixed feelings on this.

Clearly, there is benefit from being able to ask technical questions related to a company’s business model and get perspectives on industry developments. Such meetings have helped inform our allocation decisions, including disposing of our entire holding in a company when its chief financial officer admitted he was “worried” about a potentially disruptive new entrant to the industry.

But conversations with management need to have a purpose and not descend into little more than a box-ticking exercise of reciprocal admiration. Additionally, fund managers run the risk of being on the lookout for information that supports the investment case rather than seeking out information that contradicts it.  By providing executives with an opportunity to talk up their company’s prospects, the danger is that those fund managers who already own the stock may hold onto positions they might otherwise offload. As for those who do not, the risk is the positive “spin” may encourage them to buy shares they would otherwise avoid. Either way, it can foster the endowment effect, where we ascribe more value to things merely because we own and are more familiar with them.

Availability heuristic

The fact price/earnings (P/E) ratios are readily available helps explain why they tend to be among the most widely followed yardsticks of a stock’s value. This is an example of what is known as the availability heuristic. But just because P/E ratios are easy to obtain does notmean they are the most effective means of selecting investments.

The trouble is that given so many analysts and fund managers use P/E ratios to guide their investment decisions, companies are incentivized to manipulate earnings in order to artificially inflate their stock price. The experience of WorldCom, Enron and other accounting frauds are reminders that earnings are subjective in a way that cash is not.

This is one reason I focus on price/free cash flow when evaluating investment decisions. Yet the market persists in reaching for the earnings-per-share figure that is served up on the front pages of results announcements around the world, rather than first turning to the cash-flow statement towards the back.

All of this is not to deny that beating the market remains extremely difficult. However, there is plenty of evidence to suggest humans are not the rational actors assumed by conventional economic and financial market theory. While this presents investors with an opportunity, in
order to maximize the chance of outperforming the market over the long run, they need to develop an investment process that takes account of and avoids some of the pitfalls common to us all.


[1]  https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors

[2]  http://psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf

[3]  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563

*Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").

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