Investing is a complex open ended system and deeply influenced by human behavior. In a closed end system, such as a car engine, a specific input of fuel delivers a consistent mileage output. This is not the case with open ended systems such as investing or the weather, where similar inputs produce varying results. This article delves into human behavior and the investment process, specifically cognitive bias, emotions and groupthink or herd behavior.
The Influence of Cognitive Bias
A foundational element of behavioral finance is the study of cognitive biases. These are systematic patterns of deviation from rational judgment. These biases can significantly impact investment performance in several ways with three common pitfalls:
Anchoring Bias
Investors often rely too heavily on the first piece of information they encounter. For example, an initial stock price can influence perceptions of subsequent price movements, potentially leading to poor investment decisions if the initial price was an anomaly or just luck.
Confirmation Bias
This bias sees investors favoring information that confirms their pre-existing beliefs and disregarding contradictory evidence. It can result in holding on to losing investments for too long, hoping for a turnaround that rational analysis would suggest is unlikely.
Overconfidence
Overconfidence in one's financial acumen leads investors to take greater risks. This bias is particularly dangerous since it exposes investors to extreme risks that they are ill-prepared to handle.
The Role of Emotions
Emotion is part of humanity with a corresponding disparate impact on the investment process. As long as human beings are making the investment decisions excessive greed and fear are a pair of pitfalls which hinder the investment process.
Fear and Risk Aversion
During market downturns, correlation approaches one for all asset classes. Fear drives investors to sell off assets, locking inappropriately sized losses, rather than riding out short-term fluctuations. Excessive "loss aversion," dampens long term performance during crisis and can also result in being under risked when markets recover.
Greed and Overtrading
Conversely, during bull markets, excessive greed leads to inappropriate portfolio sizing and overconfidence. This lack of discipline can quickly morph into fear resulting in significant losses in market corrects.
Groupthink and Herd Behavior
Investors don't make decisions in isolation; they are influenced by the behavior of other investors. This can lead to the powerful pitfall of herd behavior, where individuals follow the majority without independent analysis. Herd behavior can inflate asset bubbles and deepen market crashes, as investors collectively rush in or out of markets.
Media Influence
The media also fosters herd behavior. It's easy to conflate media opinions with investment expertise. Positive news or negative news can cause disproportionate price movements despite the fact the media is in no way accountable for the results of their reporting.
Mitigating The Human Factor
Understanding psychological influences is the first step in mitigating their effects. This does not mean a purely quantitative investment process assures investment performance. Instead, identifying common human pitfalls helps dampen their adverse effect on the investment process.
Diversification
Over diversification can dilute investment performance. However, sufficient diversification allows investors to mitigate lessen the impact of any single cognitive bias or emotional response.
Adhering to pre-investment discipline
The original investment thesis, valuations and stop loss for any investment may be subject to bias, however the potential for irrational fear, greed, style drift, or emotional attachment to a faulty investment thesis can increase significantly once invested.
Experience and Via Negativa
Experienced investment managers know the nuances of asset classes and characteristics of a quality investment process. They also know successful investing is partly "Via Negativa" or the study of what not to do. There is no substitute for this experience in complex open ended systems like investing.
A partner you can trust
A quality investment process balances quantitative metrics while understanding the pitfalls of human behavior. Investors who scrutinize and remind themselves of these behavioral science challenges can reduce their adverse impact on performance.
Resonanz Capital works with the best hedge fund professionals available. We have a proven track record of successfully handling complex strategies. Our experienced hedge fund management process has produced substantial capital gains with low market dependence, while outperforming peers.
Contact us today, as we guide you towards generating value through hedge fund investments.
