Regret and hindsight bias come together in the selection of loser stocks for a portfolio. As I discussed in chapter 3, a portfolio of losers historically outperformed the market by 19 percent on a cumulative three-year basis. But when losers continue to lose, their continued poor performance looks inevitable in hindsight; and it is easy to imagine having avoided them. Indeed in chapter 7, I noted that Werner De Bondt and Richard Thaler, who discovered the winner-loser effect, found that people, including themselves, were fearful of investing in loser stocks.
Heuristic-Driven Bias and Portfolio Selection
Individual investors are especially prone to heuristic-driven bias. Here is some intriguing evidence from a survey of individual investors conducted by De Bondt (1998). A group of forty-five investors were recruited at a conference organized by the National Association of Investment Clubs. Two thirds were men. The average investor in the group was fifty-eight years old, had been trading stocks for the previous eighteen years, and had a financial portfolio (excluding real estate) worth $310,000 that was 72 percent invested in stocks. He or she spent seven hours per week thinking about his or her investments, time that included viewing the television program Wall $treet Week with Louis Rukeyser.
Over a period of twenty weeks, De Bondt tracked the group’s forecasts for the future performance of both the Dow Jones and their own stocks. Four of his findings are especially fascinating. (1) Investors were excessively optimistic about the future performance of shares they owned, but not about the Dow Jones. (2) They were overconfident in that they found themselves surprised by the price changes to their stocks more frequently than they had anticipated. (3) Their stock price forecasts were anchored on past performance: During an uptrend for one of their stocks, investors thought there was little room left for movement on the upside but a lot of room on the downside. The reverse held true for downtrends.12 (4) They underestimated the degree to which their stocks moved in tandem with the market. In other words, they underestimated beta.
Equally interesting are the attitudes that De Bondt’s investors expressed. (1) When it comes to picking stocks, they certainly do not believe in throwing darts. (2) Investors stated that they believe a solid understanding of a few firms is a better risk-management tool than diversification. (3) Not only do investors reject the notion that beta measures risk, they reject the fact that risk and return are positively related.
De Bondt’s survey informs us that individual investors
• display excessive optimism,
• are overconfident,
• discount diversification, and
• reject there being a positive tradeoff between risk and return.
In the next few sections, I take up these issues in detail.
Optimism
Let’s return to O’Neill’s (1990) book of financial planning case studies. Those studies provide a sense of how eclectic, and problematic, the portfolios of individual investors can be. Her examples cover a multitude of sins such as inadequate insurance coverage, the failure to diversify, and excessive risk taking.
Why do so many people appear to have inadequate insurance coverage? Included in her group are the Smyths, whose case we discussed earlier. They lack long-term disability insurance. And the Smyths have plenty of company, especially from people in their twenties. This is one case of insufficient fear. O’Neill points out that the “twentysomethings” are seven times more likely to experience an extended disability than they are to die young. Presumably, they are unduly optimistic.
In fact, excessive optimism is a well-studied phenomenon, especially among people in their teens and early twenties. Psychologist Neil Weinstein (1980) found that people in this age group systematically think that they are less likely to experience bad outcomes, and more likely to experience good outcomes, than their peers. In replicating Weinstein’s study, I have found that the same phenomenon holds true for people between the ages of 25 and 45, though to a lesser degree than for the younger cohort.
Overconfidence: Too Much Trading
Outside their 401(k) plans, many investors earn mediocre returns because they trade too much. A study by Brad Barber and Terrance Odean (1998b) finds that individual investors tilt their portfolios toward high-beta, small-capitalization value stocks.13 Barber and Odean examined the trading histories of 60,000 investors over the six-year period ending in 1996. They found that during this time, individuals managed to beat the value-weighted market index by 60 basis points, although that was gross of trading costs. Trading costs ate up 240 basis points of returns. Not surprisingly, the individuals who traded most fared the worst, underperforming the index by 500 basis points.
Why do individual investors trade so much when the net effect is to reduce their returns? Clearly, they believe they can pick winners. But Barber and Odean suggest that investors are overconfident in their abilities. There is good reason to expect that this is the case, since overconfidence is ubiquitous, especially when difficult tasks are involved. Investors may also overrate their abilities. As noted in chapter 4, I asked my MBA students to rate themselves as drivers relative to the general population. Only 8 percent rated themselves below average; 65 percent rated themselves above average. The 65 percent figure may actually be low. Kahneman and Mark Riepe (1997) report that the general figure is more like 80 percent.
There is at least one additional explanation for why people trade so much. Lopes (1987) suggests that people are motivated to master their environment, and it is unpleasant to believe that one has no control, especially when chance and skill elements coexist. The trading of stocks fits this bill. Investors who are high in the desire for control and suffer from the illusion of control are prone to trade frequently.
The Online Revolution
Overconfidence, desire for control, and the illusion of control appear to be especially acute when it comes to online trading, Internet stocks, and day trading.
Online trading has made it cheaper and easier for individual investors to trade stocks. Between 1996 and 1998 the average commission charged per trade by the ten largest online trading firms dropped by about 75 percent. The amount of assets managed online went from near zero to about $100 billion in 1997. On June 1, 1999, in a move that may dramatically change the brokerage industry forever, Merrill Lynch broke from its traditional, high-cost, full-service approach and announced its intention to enter the low-cost business of online trading.
In 1998, Internet stocks captured investors’ attention, especially those of online traders. On the strength of investors’ imagination, and little else, Internet stock prices were propelled into orbit. According to Lipper Analytical Services the best-performing mutual fund in 1998 was the Internet Fund, managed by Kinetics Asset Management. It had a return of 196 percent.
Overconfidence and optimism appear to be particularly severe among day traders, the online traders who have abandoned regular jobs to trade full time from their personal computers. The lure of day trading has soared with the appearance of best-selling books and Web sites devoted to the subject.
Some things never change. Statman and I (Shefrin and Statman 1993b) discuss the evolution of the 1933 Securities Act and the 1934 Securities Exchange Act as a response to the fate that befell optimistic, overconfident traders in the 1920s.14 Legislators enacted limits on margin and suitability requirements as a means of mitigating insufficient self-control (gambling addiction) and heuristic-driven bias. On January 27, 1999, Securities and Exchange Commission chair Arthur Levitt warned that online trading was like “a narcotic” to many online traders.15 The technology may have changed over the last seventy years, but human psychology has not.
Generally speaking, most online investors are between 25 and 45 years old. In 1998, about 75 percent of online traders were men; the most active online cohort was the 30–34 age group. Investors in this age group are especially prone to optimism and overconfidence. A PaineWebber study found that younger investors were more optimistic than older investors were. (See chapter 5.)
The Failure to Diversify
The failure to diversify is by now a well-documented phenomenon. One investor who computes mean-variance efficient portfolios for a living confided to me that he had but one stock in his individual retirement account (IRA). Needless to say, I was curious as to which one. The answer? Microsoft. He told me, “I let Bill Gates manage my IRA.”
Virtually all academic studies of individual investors’ portfolios find that they only contain a few securities. For example, an early study by Blume, Crockett, and Friend (1974) found that 34.1 percent of investors in their sample of 17,056 investors held only one dividend-paying stock, 50 percent held no more than two stocks, and only 10.7 percent held more than ten stocks. A Federal Reserve Board survey on the financial characteristics of consumers showed that the average number of stocks in the portfolio was 3.41 (Blume and Friend 1975). More recently Martha Starr-McCluer (1994), an economist at the Federal Reserve Board in Washington, reports similar findings based upon the Survey of Consumer Finances, sponsored by the Federal Reserve Board.
Lease, Lewellen, and Schlarbaum (1976) surveyed investors who held accounts with a major brokerage company and found that the average number of stocks in a portfolio ranged from 9.4 to 12.1, depending on the demographic group.
While we know that there are only few stocks in the typical portfolio, it is possible that diversification is accomplished through bonds, real estate, and other assets. However, evidence by Mervyn King and Jonathan Leape (1984), as well as most of O’Neill’s case studies, indicates that limited diversification is observed even where assets other than stocks are included.
It is abundantly clear that individual investors have a very primitive understanding of what constitutes a well-diversified portfolio. In The Investment Club Book, John Wasik (1995) indicates that the National Association of Investors Corporations (NAIC), which represents 8,000 stock-picking clubs, advises that portfolios include no fewer than five stocks. The NAIC calls this the Rule of Five. The theory is that of the five stocks, one will probably be a loser, three will produce mediocre returns, but the fifth will be a real winner!
Of course, the number of securities in the portfolio is not the sole determinant of the proximity to mean-variance efficiency. Jacob (1974) and others have shown that an investor can reduce unsystematic risk significantly with only a few securities by a judicious selection of securities. However, Blume and Friend (1978) report that the actual degree of diversification for 70 percent of the investors in their study was lower than suggested by the number of securities in the portfolios.
Naive Diversification
Shlomo Benartzi and Richard Thaler (1998) have written a most intriguing study of the way many investors approach diversification in their 401(k) accounts. They present strong evidence that individuals divide their money evenly across all the choices their 401(k) plan makes available. So, if their plan offers them one bond fund and one stock fund, they will split their contributions fifty-fifty. This is what Harry Markowitz acknowledged doing in his own retirement account (1998).
If there are three choices, a money market fund, a bond fund, and a stock fund, then investors will split their contributions three ways equally. Benartzi and Thaler call this heuristic the 1/n rule, and characterize it as naive diversification.
The heuristic is important because depending on how the choices are structured, individuals can end up taking too little risk or excessive risk, relative to their risk tolerance. Somebody whose employer offers a plan that has two bond funds and one stock fund will end up with one third of their allocation in equities. However, the reverse will be true for someone who works for a company like TWA that offers a plan with more stock funds than bond funds.
Home Bias: Familiarity Does not Always Breed Contempt
Although U.S. stocks only account for 45 percent of global market value of equity, U.S. investors tend to concentrate their holdings in U.S. stocks. This phenomenon is called the home bias. Ken French and James Poterba (1993) point out that in 1989 U.S. investors held less than 7 percent of their portfolios in foreign securities. Moreover, Europeans concentrate their portfolios in European stocks, and Japanese concentrate in Japanese stocks. Why?
In a word, familiarity. Remember the aversion to ambiguity discussed in chapter 2? In unfamiliar situations, the predominant emotion tends to be fear. Foreign stocks are less familiar than U.S. stocks. Perhaps familiarity also explains why, in their portfolios, people tend to overweight the stocks of companies they work for. Gur Huberman (1997) points out that U.S. investors concentrate their holdings in the Baby Bells—the former Bell operating companies—of their own region. Of course, investors who shun the Baby Bells of other regions, like investors who shun foreign stocks, give up some of the benefits of diversification.
Summary
The major factors driving portfolio selection are much more complex than the mean and variance of future returns. This chapter described how frame dependence, heuristic-driven bias, and the emotional time line together shape (1) the kinds of portfolios that investors choose, (2) the types of securities investors find attractive, (3) the relationship that investors form with financial advisers, and (4) the biases to which investors are subject.
The key emotions pertain to fear, hope, and the aspirations attached to investor goals. Heuristic-driven bias stems from a variety of phenomena: naive diversification rules such as the “Rule of Five” and the “1/n” heuristic, hindsight bias, excessive optimism, overconfidence, self-attribution bias, and fear of the unfamiliar.
Chapter 11 Retirement Saving: Myopia and Self-Control
When it comes to planning for retirement, Americans delude themselves.
Anyone wanting to plan successfully for retirement recognizes the need to accomplish a series of key tasks.
1. Identify financial needs during retirement.
2. Save an appropriate amount over time.
3. Select a portfolio of assets with a risk-return profile that is appropriate for reaching their retirement goal.
4. Have procedures in place to prevent those assets from being consumed too early.
This chapter discusses the following:
• why investors need to overcome myopia and exercise self-control in order to save for retirement
• why investors find dividends attractive, and use frame dependence to save more
• how investors use mental accounting and dollar-cost averaging to save and manage the risk in their portfolios
What are the psychological phenomena in question? First comes myopia, leading to shortsightedness and low tolerance for risk. Low risk tolerance primarily stems from loss aversion. Next comes overconfidence: Investors seem pretty blasé about having sufficient resources in place for retirement, despite the absence of clear retirement plans. Third, inadequate saving is essentially a self-control problem that occurs because the temptation to consume now is especially strong. Exercising self-control involves the cultivation of good habits, and good saving habits make good use of mental accounting. That is, good savings habits exploit frame dependence.
The chapter is organized around the household life cycle that begins with the road to retirement—the working phase when accumulation occurs, the onset of retirement, and culminates with the retirement phase itself. At each stage of the life c
ycle, I discuss the psychological impediments to saving adequately for retirement and present frame dependence–based measures that can be used to overcome these impediments. To introduce the main ideas, I begin with a short case.
Case Study: Myopia and Facing the Road to Retirement
Ira Roth and his wife, Jeannie,1 are working professionals between the ages of 20 and 50. Ira, age 45, is vice president in charge of global operations for a well-known technology company based in Southern California. Jeannie, age 40, is a stay-at-home mom who looks after the couple’s two young daughters.
Ira Roth has been able to save successfully and has accumulated a substantial amount in his regular IRA. Together with the funds in his 401(k) plan and some taxable investments, he and Jeannie have substantial financial resources set aside for retirement. But they also want to retire early, by the time Ira reaches age 55, and are unclear whether their nest egg will enable them to do so. This is the main reason they decided to consult a financial planner. But they have another reason. Ira’s father, Max, just retired at age 65, and quickly came to the shocked realization that his total financial assets amounted to just $30,000.
Max Roth suffered from myopia when it came to planning his retirement, a common occurrence. His lack of foresight spurred Ira and Jeannie to assemble a financial plan for themselves. They will be helping Max out but do not want their daughters to have to do the same for them.
Financial planners routinely ask their clients to answer questions that indicate the extent to which the clients’ financial affairs are in order. For example, a client might be asked to answer a series of questions such as the following:
Beyond Greed and Fear Page 19