The Psychology of Investing

In this episode, we examine the crucial intersection of psychology and investing, highlighting how emotions and narratives impact market behaviour. Drawing from Darrel's experience as a professional investment analyst, we challenge the view that investing is solely quantitative, showcasing how factors like meme stocks and cryptocurrencies illustrate this point. We discuss behavioural finance biases, such as authority bias and herd behaviour, that can mislead investors. With practical strategies for reducing emotional decision-making, we emphasize diversification and systematic investment approaches.

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Transcript

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Okay, welcome back to Rational Markets. So today we'll be talking about the psychology of investing. So if you've watched or listened to some of the more recent episodes, you've already kind of seen the why behind Rational Markets, why we're doing this. And I felt that this was a good place to start before I dive into some of the more technical topics, because I think for most people, when they think about finance, they think about numbers. They think it's purely a numbers game. They think of stock charts. They think of prices. They think of flashing red and green lights on a screen. You know, they think of price ratios. They think of balance sheets, financial statements. And to some extent, they're right. You know, those things are all a part of finance, right? So there is a lot of math and stats and data involved in traditional financial analysis. And having spent, you know, seven years studying finance, both in university and through the CFA program, I would say that maybe about 70% of what I've learned was quantitative in nature. So, you know, memorizing formulas and things like that. um so i can understand why people you know have this uh you know preconception but at the same time i would say it's not purely a quantitative field and this is really what i learned through actually working as an analyst in the capital markets i would say uh you know the schooling really didn't prepare me for this and didn't really i would say sufficiently kind of, illustrate the importance of some of these other aspects. And if you back up and think about it, it makes sense because. If finance were purely quantitative, if it were just purely a quantitative field, there would be this perfect one-to-one correlation between mathematical ability and investment performance, right? So the best investors would simply just be the best mathematicians. Clearly, that's not what we see out in the world, right? So I'm sure the best investors have these skills, but it's not quite that simple. There's something more to it than that. And that's really something that I want to emphasize. And another reason is that over the last few years, I think that the markets have become increasingly driven by narrative. And by that, I mean stories. So stories about certain companies, about certain investors, about certain founders and investment trends and macroeconomic trends. So these are all things that tend to play on our emotions, these stories, right? They're not things that you can really quantify and put a number to. And so the rise of this kind of narrative or you know so-called feels based investing. Um you know necessarily means there's been a little less emphasis on some of these more traditional valuation methods that you learn about from textbooks which is not to say that there's no room for for those things i'd say they're they're still you know part of the toolkit it's also not to say you know which is right and which is wrong it's just simply an observation that I've had that, you know, there's this kind of rise of story-based investing. And I think good examples of this are meme stocks, right? So we'll talk about more. We'll talk more about this later in the episode. But I would say, you know, meme stocks are very much, you know, an example of how important stories can be in the market, as well as entire asset classes like cryptocurrency. You know, a lot of those are very much driven by, you know, the stories that people tell around them and they don't tend to kind of fit neatly into traditional kind of boxes or valuation techniques, as well as what's happening now with AI stocks. You know, I think a lot of people are questioning, you know, when they look at the financials and the amount of investment that's taking place in the AI kind of sector, if you will. And, you know, I would say that's another example of, you know, how important story can be when it comes to investing. And so I would say that understanding this qualitative side of finance is really crucial if you want to become a better investor. But I think it's also key in understanding why things happen the way that they do in the market that seem to defy logic and seem to defy traditional analysis. And so the goal here is really to gain insight and awareness into some of these more soft elements, if you will, these psychological elements that drive the markets and ultimately drive our own behavior as well. This is really about gaining understanding and awareness both inside and out. Okay, so to get into it, before we talk about some of the more psychological aspects of finance, I think we have to touch on something called fundamentals. So if you watch or listen to traditional financial media like Bloomberg or CNBC, you'll often hear this term thrown around, right? The fundamentals of a company, the fundamentals of a market. And simply it refers to the way that companies. Businesses, markets are traditionally evaluated, which is really about forecasting how profitable a certain business will be into the future, how strong its products are how strong its assets are compared to its competition as well as its financial health so how much debt does it have relative to cash that it has on the balance sheet cash that's bringing in, and the strength of its management team, right? Like how reputable are the C-suite, et cetera. You know, so this kind of basket of things is traditionally what people call fundamentals. And usually, you know, in history is how people evaluated companies, right? And I would say this is financed by the books, right? It's what you learn about in business school. It's what you learn in programs like the CFA. And it is very much, I would say, still an essential toolkit. It's very much important to know these things when you're investing or you're a professional in finance. But having said that, it's not all-encompassing. It's not everything. Why? Why isn't it everything? It's because most of these financial theories and models are math, right? And in order for math to work, you have to make certain assumptions, right? And it's necessary. It's basically... In most cases, right, most kind of economic models and financial theories assume that markets and the investors that make up these markets are perfectly rational. What does that mean? It means that people function more or less like walking calculators, right? They assume or they make their investment decisions based on risk and return. So they try to minimize the risk and they try to maximize the return. Makes sense, right? This, I would say most people, you know, if given the option, they would kind of do things that way. But it's a little bit more complicated than that, obviously. And as a result of that behavior, asset prices, so stock prices, housing prices, any kind of asset price is therefore also rational, right? Basically perfectly reflects all the information out there is basically just just the calculation right but if you've been paying attention to recent trends in the market or if you're just experienced right if you've been in the market for long enough you probably know that this is not an accurate representation of the world right this kind of perfectly efficient uh view of the world is uh you know it has its usefulness, right? It, again, makes it so that we can talk about things in a simple way, but it's, I would say, overly simplistic. Which brings us to this topic of behavioral finance. And so by now, it should be fairly obvious that this, perfectly rational investor archetype, this like cookie cutter model that you see about, that you read about in textbooks is really a myth. It doesn't exist. And behavioral finance acknowledges this. It doesn't try to sweep these things under the rug. It kind of faces it head on and says, yes, we're not perfect. So behavioral finance is really the study of why markets and investors don't always behave rationally. Specifically, it focuses on some of these other factors, these psychological factors such as emotions and cognitive biases that influence the behavior of investors and therefore also the behavior of markets at large, right? And therefore stock prices, right? And there are way too many biases for us to go through, right? This is certainly not a class in behavioral finance by any means. So we won't get into everything, but we'll discuss some of the common ones that I think should illustrate the impact of the behavioral element in markets and how it's often just as important, if not more important, than the quantitative side. And so my goal isn't really to make you dwell on your flaws, right? We're all human. We're all emotional creatures. Really, my goal is to show you that it's this human aspect that makes finance so interesting, at least to me. And we can't just bury our heads in our Excel spreadsheets and our textbooks. We want to truly have a holistic understanding of the markets and be better investors. And speaking for myself, I used to live in this so-called model land where, you know, I thought that all the companies I covered could be, perfectly explained, right? All the valuations could be perfectly explained through financial models that I had built or my colleagues had built and Wall Street had built. Everything should fit in this kind of perfect little mold. In hindsight, that's quite silly, right? Because math is really just one piece of the puzzle. And not only that, but we're just one participant in the markets, right? Whether we're investors or institutions, no matter how much capital um you know we're we're deploying we're we're really just one uh voice in in the broader collective right and we have to recognize that i would say um so you know the human element is just as important um if not more important and that's something i really want to emphasize so i think some of the more recent examples of the limits of fundamental analysis uh include these so-called meme stocks, as well as cryptocurrency, but I won't talk about that as much. You know, by any sort of fundamental measure, these assets have valuations that really can't be justified using traditional methods, right? So in the case of crypto, you know, it's not a stock because it doesn't represent ownership in company, which generates cash flows, right? Which, you know, you have a way of valuing something like that. Instead, it probably makes more sense to value a crypto like a currency, right? Because it's a medium of exchange. Even by that means crypto can't really be valued using these traditional methods because it's not linked to interest rates, right? By definition, it's, you know, decentralized, it's not linked to a central bank, it's not linked to a country. And so you can't look at things like capital flows, you can't look at trade balances or anything like that. And so, you know, again, really hard to To look at prices of digital assets and, you know, make sense of it using these traditional methods. And, you know, another example that I think a lot of us are probably familiar with is the story of GameStop. Which I would say is kind of the poster child of meme stocks. And, you know, I won't get into too much detail about this, there's obviously a ton of material out there if you're interested. And I'm sure a lot of you participated in this, but, you know, during the pandemic, a lot of us were stuck at home, right? And some folks were given stimulus checks. So they had a lot of money to play with. And there were these kind of online trading platforms like Robinhood that were getting more and more popular and they were making trading easier. And so people were trading on their cell phones. And then there were subreddits like WallStreetBets, where people were kind of, you know, aggregating together and comparing notes and they were rising in popularity. So there was this kind of confluence of factors that really kind of led to the story of GameStop. And again, there's tons of analysis on this. There's even a Hollywood movie about this. So, you know, I won't get into that, but suffice it to say that, you know, GameStop saw its stock rise from $1 a share in January 2020 to nearly $500 a share a year later with very little, if any, change to its underlying business, right? So nothing really changed, but the stock went from $1 to $500, right? So really hard to make sense of that. And I would say a lot of this was driven by her behavior. And so some people might call this FOMO or fear of missing out. But people were posting their returns through GameStop and options on GameStop on Reddit. And everybody wanted in on this. It was very much this kind of collective moment. And there was this emotional and cultural layer as well. It's the first time that I'm aware of that you had this massive amount of retail investor interests rally around a single stock and essentially bring down a hedge fund, which I'd bet against GameStop through something called short selling. And, you know, obviously making money was part of what people were after. It was a big motivation, but it was also a cultural event, I would say, where a lot of investors saw an opportunity to take down a hedge fund, and they wanted to be part of this cultural moment. And just to back up a little bit, short selling for those who are uninitiated or don't have experience with this, it's essentially a bet that pays off when an asset price falls. So it's a very risky trade. I would say not advised for most individual investors is typically reserved for hedge funds whose investors tend to have a bit more risk tolerance and they allow the hedge funds to take these kind of big bets, these big contrarian positions. And short selling is basically the opposite of buying a stock. So, uh, short sellers make money when the stock price goes down and they lose money when the stock price goes up. So it's basically just, just the inverse, the inverse relationship that you typically have. Um, and Melvin Capital, which is the hedge fund that had a large short position in GameStop, I've reportedly lost close to 7 billion from the position and had to shut down. And so I think this example of GameStop really perfectly encapsulates how powerful emotions can be, you know, and narrative and culture, all these things can really drive markets in a big way. And in fact, these factors were so strong that they actually overturned a hedge fund and its army of analysts, right? So people tend to think of these hedge funds as the smart money, but, clearly nobody is safe, right? So another example that I want to share is a bit more personal. And this was back in 2015. And I was an analyst covering US energy companies. And one of the companies I covered was called Pioneer Natural Resources, which was a large independent oil and gas producer with assets in Texas. Again, not the focus of today's conversation, But, you know, like a lot of financial firms, you know, the company that I worked at had this open concept office, right? Some people call it the bullpen, but basically, you know, everyone in the office could hear and see each other and everybody could see this TV that was placed in the center of the room. And, you know, the TV was always playing either CNBC or Bloomberg, right? And so on that day, Dave Deinhorn, the founder of Greenlight Capital, was on this TV and he was presenting at the Soane Investment Conference. And this was kind of a notorious conference, still is, for big name investors to kind of present their investment thesis around a certain stock. So they might be favorable towards the stock, they might be unfavorable. But in this particular instance on this day david einhorn was presenting his short thesis for pioneer right the company that covered and basically he thought pioneer was a bad investment that it was overvalued that the company was misrepresenting the value of his assets and so on right. And this was really unfortunate for me because this was a company that I cover, but not only that, I had published positive research about this company. And so, you know, all of our institutional investor clients knew that, you know, we liked the company, right? And so this was very much challenging that view. And if you can probably imagine, the stock price reacted in real time, right? So I was watching this on TV, you know, Mr. Einhorn was presenting his thesis and the stock was dropping pretty much in real time. So it dropped about 3% that day. Needless to say, my phone and my email did not get a break that day and I had to scramble to put a response together. But the point of the story is not about Pioneer. It's not about Greenlight Capital or me. This situation I think really just illustrates that markets are not perfectly rational because you know by all accounts nothing had changed about Pioneer the only new piece of information was that David Einhorn had a negative view on the company, uh and he was a well-known figure with a lot of you know credibility a lot of cachet and the market basically gravitated to that and they reacted to that out of fear and so people were thinking you know our investor you know our investor clients were thinking you know what if he's right um you know he's obviously a famous investor with you know billions under management so he must know something that, you know, either you don't or I don't. And so this is called authority bias. This is where someone assumes that information is correct simply because it came from somebody with credibility or an authority figure, right? So, you know, in this case, Pioneer was ultimately acquired by ExxonMobil at a valuation that was actually nearly double what it was trading for at the time of the short thesis coming out. So, you know, the point is not to talk about who was right or who was wrong in this situation, right? I think contrarian views are essential. You know, it's, you know, people might not like short sellers, but they serve a purpose, I would say. They keep companies honest. But rather, it's really to illustrate that we shouldn't just automatically flock to news or the latest kind of celebrity investor. We should really try to think critically about the information that we consume, whether it's investment related or otherwise. And so to bring it all together, these biases that behavioral finance really explores are a fundamental part of the markets, right? As much as we like to think that things are neat and tidy, they're not. And you know, it's a part of our own wiring as well as investors, as humans. And so authority bias, for example is a very common one you know it could be seen in both the pioneer example as well as the gamestop example that i talked about so this is where you know famous institutional investors were involved and they were given the benefit of the doubt initially, But I think it really shows that if we ignore our own due diligence and we ignore other factors in the market, if we just kind of flock to authority, flock to the celebrities, if you will, that can be really dangerous. So I think it's really important to maintain your own kind of point of view, your own critical thinking. And another common psychological phenomenon is something called herd behavior, right? And this, again, also called FOMO, where people are jumping onto the bandwagon because they don't want to miss out. Again, this can be seen in both those examples I talked about, right? Pioneer and GameStop, where folks were, you know, instead of thinking critically, they were just piling in without kind of reflecting and thinking critically. So really kind of being reactive with their actions. And I think it's really key to point out that these biases can go in either direction right it's not just in in the positive uh direction or the negative direction they can push prices to levels that can't be justified uh by the by the fundamentals or they can cause mass panic right and massive kind of price uh collapses so in either case we really need to be aware that these forces are strong right and they can overwhelm fundamental analysis, and they can persist for long periods of time. So, you know, as much as, um, you know, academic finance might like to think that things are neat and tidy, these things, uh, you know, things can be mispriced for, you know, by traditional methods for very long periods of time. And, uh, I think that's very important to keep in mind. So hopefully at this point, you can see that, you know, financial theory is useful. It has its place, but it's limited, right? It has its limits. And at the end of the day, we're not emotionless calculators. We're human beings where emotions often drive our decisions as much as we like to think that we're rational. So the best that we can do is, I would say, recognize these biases when they arise and just try to catch yourself when you might be acting irrationally or acting out of emotion. Just take a step back and really think about some of these biases, right? Am I doing this because I truly think that this is the way to go or am I just acting out of fear, acting out of FOMO, what have you? And institutional investors are well aware of this, right? So these large firms that manage billions of dollars, this is their forte, this is what they do for a living, and they can build safeguards. So they often have these layers of controls, they have these investment committees. So investments and positions have to go through all these hurdles before they're put in place, which makes it a little bit more manageable from their position. And they can also do things like hedging. so they can prevent themselves from getting hurt from one bad trade going the wrong way. But, you know, as individuals, we don't have quite as many tools at our disposal most of the time. So the best that we can do, I would say, is diversify, right? So not going all in on a single volatile stock or a cryptocurrency, unless you truly are willing to part ways with that money, right? If you really feel strongly about the investment and you're willing to lose that money, I would say that's fine, but for most people, not advised. We can also do things like automate deposits into investment accounts, as well as enroll in things like drip programs, which are where dividends are continuously reinvested. So this takes some of the emotion out of investing and makes it so that it's a more kind of methodical process that's not as influenced by our biases. And sometimes the best trade is the one that you don't make. So I hope at this point you understand a bit more about the role that psychology and emotion has in investing. And so if you found this helpful, please stick around. Next, we'll talk about the incentives that drive the information that we consume as investors, whether that's press releases or investor presentations. We'll also talk about the roles of investment banks, the roles of analysts, and how these roles are beginning to shift in today's world. And you can also find more in-depth essays on our sub stack. The link is in the description. And just want to thank you for joining, and we'll see you next time.