Behavior of the Experts

“Investors are neither rational or irrational. They’re human.” – Jason Zweig

Jason Zweig talked with Russ Roberts on the EconTalk podcast this week. I never realized that Zweig helped Daniel Kahneman write one of the best books ever published on behavioral psychology — Thinking, Fast and Slow. Zweig spent two years working with Kahneman on the process and discussed one of his biggest lessons:

 He [Kahneman] had sort of warned me that people who study psychology and the pitfalls of the human mind are no less prone to making errors of judgement and cognition than people who don’t know anything about it.

As a society we probably have a problem with hero worship as we place way too much faith in experts and celebrities.

This is especially true in the finance industry. There’s been a huge backlash against Wall Street since the financial crisis but far too many people still believe that intelligent sounding individuals or those with a good sales pitch in financial services are all-seeing and all-knowing. People assume professionals should have everything under control because this is what they do for a living, but it just opens you up to a whole host of different biases when you’re dealing with this stuff on a daily basis.

Individual investors are often referred to as the “dumb money” or “muppets” because everyone figures that mom and pop is the group making all of the mistakes in the markets. And it’s true that loss aversion and fear and greed drive many investors to chase fad investments or buy high and sell low.

The problem is that professional investors and advisors are prone to these same mistakes. Cognitive dissonance is alive and well in the financial world, but our psychological errors are usually caused by a different set of factors. Investment professionals tend to get overconfident and lack the necessary intellectual honesty or humility to make well-reasoned decisions. Incentives and career risk can also cause the pros to make poor decisions with huge sums of money at stake.

A good case in point this week comes from Meb Faber who pointed out a survey of institutional investors and their return expectations for their hedge fund investments:

I was skimming this recent publication from BNY Mellon and FT remark when a particular graphic caught my eye. Below is a survey from 400+ real money institutional respondents (we’re talking endowments, pension funds, insurance companies, and sovereign wealth funds). This is their estimate of the net returns they will receive from their hedge funds:

1% say 6-8%

32% say 9-11%

30% say 12-14%

32% say 15-17%

5% say 18% or more

Assuming the middle of each range that means the institutions are expecting their hedge funds to return 13% per year.

Have you lost your @!$%X# mind?

Faber says they’re all delusional and I agree.

There is a default assumption that success in one arena of life must automatically translate into success in others. Or that individuals or organizations with millions or even billions of dollars at their disposal have to be the smartest people in the room. So people tend to take what they say or do as gospel without ever questioning their methods or checking their results.

Something very few clients ever bother asking their potential financial advisors or investment managers is the question of, “How will you avoid the psychological pitfalls and behavioral traps caused by human nature when managing my money?”

And even fewer financial professionals ever bother to explain how they will be able to keep their own behavior in check for fear of coming off as anything less than perfect in the eyes of their clients. This leads to misplaced expectations and the potential for even larger mistakes down the road.

Everyone has a lesser version of themselves that they’re constantly battling with — even the so-called experts. We all need our own set of behavioral checks and balances. Investors spend far too much time in the due diligence process worrying about past performance and not enough worrying about future behavior.

Jason Zweig on Finance and The Devil’s Financial Dictionary (EconTalk)
Institutional Investors Are Delusional (Meb Faber)

Further Reading:
Managing Someone Else’s Emotions

Here’s the stuff I’ve been reading this week:

  • Bill Simmons breaks free (THR)
  • Make Neanderthals great again (A Teachable Moment)
  • Explaining investing in ways that actually make sense (Motley Fool)
  • The iron rules (Irrelevant Investor)
  • 11 signs you own the right portfolio (Jonathan Clements)
  • Opportunity cost and the concept of enough (Finance Buff)
  • The worst mutual fund in history (Dividend Growth Investor)
  • Why housing is about to eat the economy (Csen)
  • Why 401k plan sponsors need independent advice (Big Picture)
  • How FinTech is changing money management as we know it (Bloomberg View)
  • In many communities McDonald’s brings people together (Guardian)
  • Big announcement this week: RWM & IMN are holding our first ever evidence-based investing conference. More details to follow (TRB) & (TBP)