In 1720, the greatest mind of his age, Isaac Newton, locked in a 100% profit selling shares in the hottest stock of the age, the South Sea Company. But caught up in the emotion of the share price continuing to rise he re-entered, tripled his bet and lost a fortune. His actions highlight the two critical roles that behaviour plays in investment returns – understanding the behaviour of others and controlling your own.
The years since Newton have seen significant progress made in understanding and cataloging human behaviour. We now know and can put names to many behaviours, particularly the systematic errors and biases that are so relevant to investors. However, knowing these individual tendencies and incorporating them into an investment framework are different matters.
For starters, what does it mean to be rational? There are many models for how people make decisions, not all of which rely on economic rationality. As Dilbert creator Scott Adams notes:
“If your view of the world is that people use reason for their important decisions, you are setting yourself up for a life of frustration and confusion. You’ll find yourself continually debating people and never winning except in your own mind. Few things are as destructive and limiting as a worldview that assumes people are mostly rational.”
Even within the narrow definition of economics, what is rational depends upon the objective you are pursuing or the incentives you are being offered. These in turn are driven by social interactions and institutional constraints. Knowledge of how groups of individuals make decisions doesn’t necessarily translate into understanding how individuals in groups behave.
Finally, thinking you understand others is blinded by the fact that you generally don’t even understand yourself. Our mind tells us only snippets of what it knows, with the result we are much better at seeing others “faults” than we are at evaluating our own.
The successful analyst and investor is the one who can see the world as it is, not how they want it to be, whilst also recognising the limitations of this vision. Seeing holistically through the systems frame is one tool for this; understanding the important behavioural aspects of the system is another. In our Behavioural Frame, we view these aspects in three baskets:
- Individual Behaviour – How the mind works and implications for individual decision making.
- Group Behaviour – How do individual decisions scale when considered in aggregate.
- Institutional Behaviour – How do institutional structures and incentives influence decision making.