The Wile E. Coyote Moment
With the great post-Armageddon bull market party in full swing suddenly everyone's an investment genius again. Back in 2008, when stocks were languishing at lows not seen since talking movies were invented, no one wanted to know. And, as usual when the bull is running, logic is taking a quiet break and considering early retirement.
Well, logic needn't bother. At some point people are going to look down and realize that they've run over the cliff edge again. The question is not if, but when, the Wile E. Coy moment will happen. The trouble is that bull markets get people thinking they’ve got brains when mostly what they’ve got is hope.
The problem with this current market is that it's built on unstable foundations, predicated on governments continuing to pump in cheap money. Clearly the hope is that by restoring public confidence a real recovery can be jump started. And, frankly, there's some evidence this is working: people are spending again, and business confidence is rising and with it the prospect of genuine investment and real rises in peoples' earnings.
Unfortunately the mess we're in isn't simple to fix. As real wages in the developed economies have fallen the only way people can spend more - and our consumerist lifestyle is based on people spending more - is by digging into savings or by borrowing more. And as most of us don't have any savings it doesn't take a genius to square that particular circle. Yet markets continue to rise, inexorably it seems.
At some point during a rising market economics starts to take a back seat and that ephemeral thing called confidence starts to kick in. Stocks are rising, ergo, stocks will continue to rise. And with this comes the corollary, my stocks are rising, ergo, I’m an investment genius. Zhen Shi and Na Wang have taken a look at this in Don’t Confuse Brains With A Bull Market and have discovered, unsurprisingly, that investors trade more in a bull market than a bear market.
Even better, the researchers show that:
“Specifically, we find that in the bull market the securities bought by individual investors significantly underperform the securities sold in the subsequent periods of one and three months. In the bear market, however, individual investors do not make the similar suboptimal trading decisions as they do in the bull market”.
So basically people trade too much in bull markets and, in the short-term at least, this causes their performance to degrade not just because of additional costs but because they buy shares that perform worse than the ones they sell. On a monthly basis the portfolio of sold stocks outperforms the portfolio of bought stocks by 0.38% (there’s no difference in bear markets): and furthermore the technique eliminates the possibility that this is due to bad market timing – it’s not, it’s purely down to individual incompetence.
All of this builds on work performed back around the turn of the century by Terrance Odean. In Are Investors Reluctant to Realize Their Losses? Odean demonstrated that the disposition effect, our tendency to sell winners and run losers, was alive and kicking and not at all justified by subsequent performance. Underlying this is our inherent bias towards being overconfident about our ability to predict the future.
Odean and Simon Gervais, in Learning to be Overconfident, then developed a model based on this, one in which we learn about our trading abilities through experience. Now you might think that this is a good thing, but Gervais and Odean suggest that we suffer from an attribution bias – we attribute success to our own abilities and failures to external stuff we can’t do anything about. And, of course, if we happen to get lucky and successful we then attribute this to our own abilities – and our level of overconfidence increases.
Following the Bull
This does not necessarily lead to the obvious outcome – overconfidence does not always beget poverty. Out of the set of overconfident traders some will get lucky and, as they’re taking more risks, they may well become very rich, and then start writing books about how to become rich by taking lots of risks. Unfortunately this is a game of odds, and following the risk-taking outlier survivors is not a winning gamble for most of us.
In fact, Gervais and Odean come up with a fiendishly convoluted lesson – that following successful traders is likely to be a losing game. Their reasoning is that successful traders will learn to be more overconfident – the attribution bias in action – and as they become more confident in their abilities they will take more risks:
“Thus, the expected future profits of a more successful trader may actually be lower than those of a less successful trader. Successful traders do tend to be good, but not as good as they think they are”.
It isn’t really surprising that this effect will be more evident during a bull market – after all, that’s when gains are mostly made, and it’s when less experienced investors will be attracted to the market. Sadly if we’re learning to invest in an environment in which we get nothing but positive feedback we’re likely to fall victim to the illusion that we’re demonstrated our superior investing intellect when, in reality, we’re simply floating up on a rising tide.
Given that such investors have little understanding of why stocks and the market are rising the onset of the inevitable bear market would, you might think, teach them a savage lesson in humility. Well no, in fact when the collapse comes it turns out that they’re not at fault: it’s the market, or central banks, or credit rating agencies or mad managements or the irredeemably hostile spirit of Aunt Edna or something. In fact it can be anything but incompetence and stupidity on the part of the investor.
Ellen Langer and Jane Roth demonstrated the impact of early success in a rigged coin tossing task. In Heads I Win, Tails It's Chance The Illusion of Control as a Function of the Sequence of Outcomes in a Purely Chance Task they had people guessing the results of coin tosses against a supposed set of outcomes. So you toss the first coin and it comes up heads and the researcher goes “Correct” or “Incorrect”. This is a nonsense of course, the outcome of coin tossing is purely random and the list of outcomes was preset: i.e. the researcher simply read out the results on the list, the actual coin tossing results were irrelevant.
The trick was that the participants were divided into two groups, both of whom got 50% of the answers “right”, but one of which was front-weighted, so that they were told that most of their initial guesses were correct, while the other group’s answers were evenly distributed. As you might suspect the group with front-weighted results came to the conclusion that they had some special skill at predicting the results of coin tossing – and their later failures had no effect on this belief.
Now I wouldn’t want to suggest that there are a lot of lucky tossers out there in the stockmarket at the moment, but if there are it’s highly unlikely that a market downturn is going to shake their belief in their investment genius. The illusion of control combined with the disposition effect will drive them onwards over the cliff, chasing the Roadrunner of illusory gains.
The lessons are easy to state and hard to put into practice. Track your returns, including those of stocks that you sell. Be humble in the face of success and don’t blame external factors for investment errors: markets are fundamentally uncertain, we’ll all make mistakes, the challenge is to learn from them, rather than persuading yourself that it’s someone else’s fault.
Attribution bias added to The Big List of Behavioral Biases.
Attribution bias added to The Big List of Behavioral Biases.