Behavioural Finance - The Biggest Enemy in Investing is Yourself
Your opening statement is the core truth of behavioural finance. While we often look for external villains—volatile markets, economic downturns, bad advice—the most significant source of investment error is our own ingrained psychological biases.
1. The Core Conflict: Man vs. "Rational Economic Man"
Traditional Finance (The "Rational" Model): This is the old paradigm. It assumes that investors are "rational actors" who:
Process all available information logically and without emotion.
Make decisions solely to maximize their wealth (utility).
Are consistent in their risk tolerance.
This model is elegant and forms the basis of theories like the Efficient Market Hypothesis (EMH), but it's a poor description of how people actually behave.
Behavioural Finance (The "Realistic" Model): Pioneered by psychologists Daniel Kahneman and Amos Tversky (Nobel Prize, 2002), this field acknowledges that investors are "normal," not always rational. They are:
Influenced by emotions (fear, greed, regret).
Use mental shortcuts (heuristics) that often lead to errors.
Systematically prone to cognitive biases that distort judgment.
The central insight is that these irrational behaviors are not random; they are predictable and systematic. By understanding them, we can defend against them.
2. Deep Dive: Recency Bias (The Party Effect)
Your notes provide a perfect case study. Let's break down the "Party Effect" and its implications.
What it is: Recency Bias is the tendency to weigh recent events more heavily than earlier ones when making decisions. Our brains are wired to believe that what happened yesterday will continue to happen tomorrow.
The Party Analysis - Why It's So Powerful:
The example of the four guests is brilliant because it shows that the exact same investment (the S&P 500 fund) can produce entirely different realities and emotions for different people, based solely on their entry point.
Guest 1 (30 months, +12.28%): Has lived through a full cycle. While uncomfortable with the recent downturn, their overall experience is positive. They are likely to stay invested.
Guest 10 (21 months, +1.36%): Feels frustrated. They missed the big early gains and have seen their profits evaporate. They are on the fence, susceptible to selling on a further dip.
Guest 19 (12 months, -21.53%): Is in a state of panic and regret. Their entire experience is negative. They believe "the market is a terrible place" and are highly likely to sell to stop the pain, potentially locking in losses at the bottom.
Guest 25 (6 months, -11.42%): Also panicked, but may hold on slightly longer, hoping to "break even." Their entire perspective is framed by the recent bear market.
The Dangerous Consequences:
Buying High, Selling Low: This is the ultimate investor sin, and Recency Bias is its primary driver.
During a bull market (everyone is making money), the recent past is positive. Greed and FOMO (Fear Of Missing Out) take over, leading people to buy after prices have already risen significantly.
During a bear market (prices are falling), the recent past is negative. Fear and panic set in, leading people to sell after prices have already fallen, crystallizing their losses.
The "This Time is Different" Mentality: Recency Bias fuels the belief that current market conditions (a boom or a bust) are a "new normal" and that historical patterns no longer apply. This leads to a abandonment of long-term strategy.
3. Other Critical Biases and Heuristics
Beyond Recency Bias, here are other common enemies in the investing psyche:
Overconfidence: We tend to overestimate our own knowledge, skill, and ability to predict the future. This leads to excessive trading, under-diversification, and ignoring contrary evidence. (Mentioned in the Yale lecture).
Confirmation Bias: We actively seek out information that confirms our existing beliefs and ignore or dismiss information that contradicts them. An investor who buys a stock will then only read positive news about it.
Loss Aversion (from Prospect Theory): This is a foundational concept. The pain of losing $100 is psychologically about twice as powerful as the pleasure of gaining $100. This makes us irrationally hold onto losing investments (hoping to avoid realizing the loss) and sell winning investments too early (to "lock in" a gain).
Anchoring: We rely too heavily on the first piece of information we receive (the "anchor"). For example, an investor might fixate on the high price a stock once reached ($150) and refuse to sell it at $80, even if the fundamentals have deteriorated, because $80 seems "low" compared to the anchor.
Herd Mentality: The tendency to follow the actions of a large group, even if it's irrational. This drives asset bubbles and crashes.
4. How to Fight Your Inner Enemy: A Practical Guide
The notes correctly state that this is the "deadliest of all traps." Overcoming it requires a systematic defense.
Educate Yourself: This is the most powerful weapon. You don't need to become a professional trader, but you must understand the fundamental principles of investing (what is a stock? a bond? what is diversification? what is a market cycle?) and, crucially, the principles of behavioural finance itself. Knowing these biases by name allows you to spot them in your own thinking.
Create a Rules-Based Plan (An Investment Policy Statement): You must make your crucial decisions when you are thinking clearly, not in the heat of the moment. Your plan should define:
Your long-term goals (retirement, a house, etc.).
Your asset allocation (what percentage in stocks, bonds, etc.).
Clear rules for rebalancing (e.g., "I will rebalance my portfolio back to my target allocation every 12 months").
This plan acts as a "circuit breaker" for your emotions.
Embrace Dollar-Cost Averaging: This technique, where you invest a fixed amount of money at regular intervals (e.g., monthly), automatically fights Recency Bias. You buy more shares when prices are low and fewer when prices are high, smoothing out your entry point and preventing you from trying to "time the market."
Hire the Right Kind of Advisor: The notes are emphatic and correct here.
Fiduciary Duty is Non-Negotiable: A fiduciary is legally and ethically obligated to put your interests first. This removes the "conflict of interest" variable. Many advisors at large wirehouses (like those mentioned: Merrill Lynch, etc.) are not held to a fiduciary standard and may be incentivized to sell you products that are good for them.
Your Advisor as a "Behavioral Coach": A good fiduciary advisor's greatest value may not be stock-picking, but being the voice of reason when you are panicking or becoming greedy. They help you stick to your plan.
Conclusion
Behavioural Finance doesn't just make us smarter investors; it makes us more self-aware individuals. It teaches us humility, patience, and the value of discipline. The market's volatility is a given. Your reaction to it is the variable you can control. By understanding that your biggest enemy is the collection of biases and emotional reflexes within you, you can build the defenses necessary to achieve long-term success.
In short: Master the market by first mastering yourself.
The Story: Welcome to the party
When describing the stock market each participant sees their portfolio’s performance from their perspective only and thus they are always “right” which leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.
Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” The question then is would everyone have the same rate of return at this party? Of course the answer is, no they would not. If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.
Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. What would the guests discuss? What would be their perspectives of the stock market?
In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.
To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4.
- Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12.
- Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36% for the 21-month period he has been invested.
- Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is -21.53% for the 12-month period he has been invested.
- Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is –11.42 for the 6-month period he has been invested.
These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.
The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. I have witnessed this irrational behavior throughout my career. No one is immune, even advisors.
