Think You're a Rational Investor? Think Again

This probably isn’t news to even a single reader, but the fact is that human judgement – even of experts - is not always 100% reliable. It relies on short-cuts that are frequently helpful, but can sometimes, in some situations, be misapplied in detrimental ways.

Behavioral explanations for investing outcomes focus on investors’ cognitive biases, and the human tendency to use simple rules of thumb to make quick intuitive decisions, with individuals’ collective decision-making mistakes translating into security price distortions.

How do these biases actually play out in the markets? By taking a look at three different factors and how they can potentially outperform, you can start to get a sense of the biases that might unconsciously be affecting your investing decisions.

VALUE

Value stocks are ones that appear cheap in light of their sales, earnings and cash flow trends. Their returns, according to proponents of the efficient-market hypothesis, have to do with investors rationally requiring extra compensation for investing in value firms, which have tended to be correlated to the direction of the economy overall, and generally have high leverage and potentially uncertain cash flows.

From a behavioral finance perspective, the outperformance of the value factor may have to do with a common decision-making mistake: people’s tendency to look at recent data trends and believe those trends will continue – colloquially called the "hot-hand fallacy". If investors extrapolate past positive sales or earnings growth data into the future, too many may overpay for growth stocks and underpay for value stocks. As a result, the prices of growth stocks may become too high relative to their fundamentals – meaning that value stocks might end up outperforming in the long run.

Another bias that may be in play here is loss aversion, which states that most people value avoiding losses over achieving gains. Loss-averse investors may perceive value stocks as riskier than they truly are, given that they are by definition underperformers.

MOMENTUM

This factor focuses on stocks that have strong price momentum, i.e. they have performed well over the past 6 to 12 months.

This outperformance may ultimately result from investors putting too much weight on their prior beliefs at the expense of new information, leading to slow dissemination of firm-specific information, delayed price reactions to news and price continuation. If investors like a stock and believe it has high earnings growth potential, they tend not to immediately adjust their beliefs in light of new negative information, an investing mistake arising from "the anchoring-and-adjustment heuristic."

LOW VOLATILITY

Low volatility stocks' excess returns may be rationally explained by leverage constraints. In the absence of access to leverage, investors may overpay for high volatility stocks in an attempt to increase risk in their portfolios, potentially leading lower volatility stocks to become more attractively valued and outperform in the future.

From a behavioral perspective, these stocks' outperformance may be due to people's tendency to overestimate small, and underestimate, large probabilities. The idea is that this tendency leads to a preference for lottery-like stocks with a small chance of a very high payoff, and this preference, in turn, drives up the prices of high volatility stocks disproportionately, which sets the stage for future underperformance. Further, overconfident individuals may veer toward riskier securities in expressing their outsized faith in their own investing and stock picking abilities, exacerbating the phenomenon.

Whether you use these factors or others in your own portfolio, it can be illuminating to try to see under the hood of market behavior to see what other investors may really have on their minds. And of course, these biases are something to watch out for in other areas of life, not just investing – sometimes, your mind has a mind of its own.