According to the case, there are various prevalent social and psychological biases. Age-induced bias occurs when older people gain investment knowledge and experience but also experience cognitive aging, which reduces their skills and capacities (Investopedia 100 Top Financial Advisors of 2019, 2020). According to research, investors’ investment performance declines as they age (Investopedia 100 Top Financial Advisors of 2019, 2020). Investing solely during specific political and climatic conditions is another illustration of psychological and social prejudice.
For instance, while a Republican president is in office, Democrats are less likely to be upbeat about investing (Investopedia 100 Top Financial Advisors of 2019, 2020). There are also local and home biases, which indicates that some investors are more likely to be more upbeat about investing when there are well-known and domestic firms (Investopedia 100 Top Financial Advisors of 2019, 2020). The performance of investments could be better by overconfidence. Several stated biases exacerbate when the information gained is imprecise, and value ambiguity is more significant.
Getting rid of certain biases can be challenging, but we can try to regulate them. Self-awareness is the first step toward controlling biases. Instead of making investment decisions based solely on emotion, we need to be aware of all the internal and external variables. A contrarian paradigm was the foundation for JP Morgan’s creation of the Intrepid Funds (Baker & Sesia, 2007). The fund’s objective was to act in opposition to everyone else. Due to this mindset, Intrepid Funds has had tremendous success.
By becoming aware of typical behavioral biases, they could do this. They used momentum stocks to profit from the overconfidence bias and value stocks to profit from the loss aversion bias as their two key investment philosophies. Realizing one’s prejudices and moderating them are the first steps in managing anchoring and recency. In order to control recency, it is critical to consider a company’s historical performance and its most recent results. Additionally, anchoring can be controlled by maintaining an open mind and approaching new information as if it were the first time.
Complin and his team thought a trading method could be used to profit from this irrational conduct that led to market oddities. There were two market oddities between 1951 and 2005 (Index Fund Advisors, Inc. (IFA.COM), n.d.). First, inexpensive stocks performed better than pricey stocks (value investing). According to a JP Morgan analysis, these equities had an average annual return of 15.8%, whereas more expensive stocks only had an average annual return of 2.8% (Baker & Sesia, 2007).
The second anomaly discussed how specific recently performing equities outperformed lately underperforming stocks (momentum investing). The same JP Morgan survey showed that investors who chose to stake their money in the year’s top performers had an average annual return of 15.2% (Baker & Sesia, 2007).
On the other hand, their average return was only 3.4% when they invested in the year’s weakest performers. Behavioral biases can be used to explain these two abnormalities as they cannot be rationally explained (Baker & Sesia, 2007). Overconfidence and loss aversion, two of the most prevalent biases, were viewed by Complin and Silvio Tarca, lead portfolio manager of the IntrepidFunds, as the primary causes of the value and momentum abnormalities.
There is no way to predict when or how long they will survive. It is known that these behavioral biases have been in humans for a very long time. It will take generations for our brains to change into reason, which may or may not be achievable. These biases are a part of who we are. For instance, there was “Dutch TulipMania” in 1637 (Hayes, 2022). Although their intrinsic value was close to nil, tulip bulbs reached a peak price of $76,000 (Hayes, 2022). This biased perception of its value has persisted for millennia and is still in the bitcoin sector today. For these reasons, it is anticipated that these investment possibilities will endure indefinitely.
Investors who do not recognize their prejudices cannot change them or overcome them. It is necessary to be self-aware in order to eradicate anything. Although behavioral biases cannot be removed entirely, they can be made aware. The asset managers in JPMorgan’s asset management business were instructed on how to control the behavioral biases of their clients. It emphasizes unequivocally that while you cannot control the conduct, you can manage it: “The unfortunate thing is that you cannot eliminate these irrational behaviors in your client, so you must manage them. This can only be done through a consistent and repeatable process” (Baker & Sesia, 2007).
Furthermore, there will be fewer profitable investing opportunities if, eventually, most investors become aware of these biases and learn to handle them. However, it is wondered if that will ever be the case. Humans will continue to behave this way, so investment opportunities will always exist.
Equity analysts amplify asset mispricings, since equity analysts are also people, they are susceptible to behavioral biases. Researchers from The University of Miami discovered that analysts are vulnerable to “in-group prejudice” in 2016 (Engelberg et al., 2020). According to this survey, analysts expect businesses with CEOs who share their demographics to perform better, which is why they rate them as a “buy” (Engelberg et al., 2020).
Analysts anticipate that a company with a different demographic than they do will perform poorly, so when the company releases a solid financial report, it comes as a surprise. The typical investor uses these analyst reports. They turn to analysts they feel will assist them in obtaining a good return since they need more knowledge or competence to do their studies. When it comes down to it, analysts succumb to the same prejudices that we do, amplifying asset mispricings.
References
Baker, M.P., & Sesia, A. (2007). Behavioral Finance at JP Morgan. Harvard Business Publishing Education. Web.
Engelberg, J., McLean, R. D., & Pontiff, J. (2020). Analysts and anomalies. Journal of Accounting and Economics, 69(1), 101249. Web.
Hayes, A. (2022). Tulipmania: About the Dutch Tulip Bulb Market Bubble. Investopedia. Web.
Investopedia 100 Top Financial Advisors of 2019. (2020). Investopedia. Web.
Index Fund Advisors, Inc. (IFA.COM). (n.d.). Web.