Why even the most elite investors do stupid things when they invest: Planet Money: NPR
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If you’re Jeff Bezos, you’re not going to let some random guy manage your money and hope for the best. You are not going to open a Robinhood account and risk everything on stocks even like Gamestop. You’re going to hire the type of investor who has a PhD in math and drives a Bugatti; a go-getter who wakes up with a turmeric latte and watches satellite images of factories in Asia to predict profits for a 3D printing company most of us have never heard of. We’re talking about the best of the best in finance.
Billionaires and gigantic institutional investors turn to these financiers because they want their investments to make as much money as possible, which requires making the right calls to both buy and sell stocks. New research confirms that they are experts when choosing which stocks to buy. But when it comes to the other big part of their job, choosing which stocks to sell and when, even those financial titans are no better than a drunken monkey throwing darts.
The story of this study begins several years ago, when two of its co-authors were arguing at the university. Lawrence Schmidt, now at MIT, was trained in the old school economics, which asserts that investors behave rationally when buying and selling stocks, carefully sifting through information about companies and by making the best possible transactions. Alex Imas, now at the University of Chicago’s Booth School of Business, was trained in behavioral economics, which claims that people’s business decisions can be – and often are – sidetracked by pesky flaws in our brains. “And we started this article with the idea of settling the conflict between the two of us,” Schmidt said.
Luckily, they met a professional investor named Rick Di Mascio. Di Mascio runs a business called Analytic, which tracks the investment activity of investors of large financial companies in order to assess and improve their performance. He had spent years collecting rich data on the trades and portfolios of the financial titans. Like Imas and Schmidt, he questioned whether these elite investors made systematic mistakes when trading. And after attending a presentation given by Imas at a conference, Di Mascio offered economists his scintillating data set. Now equipped with the data, Imas and Schmidt could finally settle their quarrel.
Fancy-Schmancy Financier Vs Drunken Monkey
Schmidt, Imas and Di Mascio joined forces with Klakow Akepanidtaworn, a financial economist now at the International Monetary Fund. Economists analyzed data from 783 large investors from January 2000 to March 2016. To give you an idea of the elite of these investors, they manage portfolios averaging nearly $ 600 million. They typically focus on maximizing returns on investment for one or two large clients, such as a multibillionaire, massive pension fund, or sovereign wealth fund.
The first part of the study of these economists assesses the performance of investors. To do this, economists compare their business decisions to what they could have done instead. And they decided to compare them to the simplest alternative investment strategy they could think of, “which almost literally throws a dart at a list of names that exist in their portfolio and buys or sells that instead of the company. that the investor actually chose to buy or sell, “Schmidt says. In other words, he’s a fancy financier versus a random dart throwing monkey.
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The first major finding of economists is that these financiers are real geniuses in terms of purchase actions. They have skills that might justify charging high fees to customers. The average stock they choose to buy outperforms the random dart thrower monkey by 1.2 percentage points. It might not sound like a lot, but, with the power of compound interest, it really does add up over time. This makes these investors rockstars in the financial world. They win these Bugattis.
But then, economists looked at the performance of these investors when sale actions. Turns out they’re bad, much worse than the monkey. The stocks that investors sold ended up appreciating faster than the stocks they decided to hold. If their clients had instead hired the monkey with the darts to randomly choose which stocks to sell, clients’ portfolios would have gained 0.8 percentage points more per year. Again, this is a huge amount in the world of finance. Goodbye Bugatti, hello Ford Focus.
So what is it ?
Economists then try to figure out why elite investors are good at buying stocks but bad at selling stocks. And the basic theory they land on is that these investors spend a lot more brain energy buying stocks than selling them.
The title of their study is “Selling Fast and Buying Slow”, a reference to the book by Nobel Prize-winning psychologist Daniel Kahneman. Think, fast and slow. The book summarizes decades of research by Kahneman and his late co-author Amos Tversky into human decision-making. This research sowed the seeds for what has become behavioral economics.
Kahneman offers a framework for thinking about the way humans think. He says people have two systems in their brains. System 2 is the most deliberative and rational way of making decisions, the one we use when we can sit down and slowly mull over the world. System 1 is the automatic and instinctive way of making decisions. This is the part of the brain that our ancestors developed when they were hunted by lions in the Serengeti. When you are being chased by lions, you have to think fast. And so we’ve evolved to use these heuristics, or simple rules of thumb, to navigate on the fly in a complex world. These mental shortcuts work most of the time, but they can also cause us to systematically make decisions that are not in our best interests.
“The title of our article basically says that people use Deliberative System 2 when making buying decisions and using the more intuitive and automatic System 1 when making selling decisions,” says Imas.
To test this theory, economists take a closer look at which stocks investors tend to sell and which stocks they tend to hold. And it turns out investors aren’t horrible at selling all actions. If a company publishes an income statement and suddenly the investor has the urge to think more deliberately about the actions of that company, their decisions about selling them improve dramatically. Their sell decisions are also much better when it comes to the best performing and worst performing stocks in their portfolio. It’s like when a stock gets brighter, they pay more attention to it and start acting like a savvy financier again.
It’s quite surprising that elite investors fall asleep behind the wheel when it comes to a lot of their work. Previous research has shown that small “retail” investors, such as those who buy stocks in Gamestop, are led astray by their mental flaws. But, we are now talking about the crème de la crème of the financial world. There are literally millions, if not billions of dollars at stake.
Imas thinks that at least part of the reason is a general idea in behavioral economics that people make worse decisions when they lack feedback. When investors buy stocks, they have something to watch and see how they are doing. They can learn from past mistakes by buying stinks and adapt accordingly. But when they sell a share, poof it’s gone. They don’t look at the alternate universe where they’ve kept the stocks and made more money at the gobes. They don’t learn from their past sales mistakes.
Schmidt says asset managers can be more focused on buying stocks because buying stocks is sexier than selling them. When you buy dark new stocks that you expect to skyrocket for some smart reason, it makes you look good at your job. You can take the head of a sovereign wealth fund to dinner and tell them why you’re a genius for investing in a neat company.
But, the bottom line is that these investment managers fail to maximize returns for their clients. Without some changes to improve their selling decisions, they’d be better off focusing strictly on buying stocks and letting “a robot handle their selling decisions,” says Schmidt.
And so, Schmidt, who has long adhered to the traditional economic view that investors trade stocks rationally, seems to have lost the fight that originally inspired this study. “My big conclusion from this article is that even when we look at a sample of extremely talented and highly incentivized expert investors, these are still people,” Schmidt said. As simple as it sounds, it contradicts a school of thought that has dominated economics for decades – a school that Schmidt once wholeheartedly embraced. Now, he said, “I think I’m converting. I think I am becoming a behavioral economist.
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