Tip for Investors: Know How Behavioral Biases Can Impact Investing

Written by Justin Sly, CFA on April 3, 2019

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Bitcoin. Cannabis stocks. Nvidia. What do all of these things have in common? They all violate the foundational theory on which the investment industry was built.

This foundational theory, known as Modern Portfolio Theory, rests on the assumption that market participants (i.e., human beings) will:

  1. Act rationally;
  2. Only make decisions with complete knowledge and information; and
  3. Seek to maximize personal satisfaction.

Modern Portfolio Theory’s ideal investment participant is what is often referred to as the “Rational Economic Man.” In theory, this idealized representation of investors makes rational decisions with complete knowledge for his own personal satisfaction. This Rational Economic Man is believed to be the driving force behind asset prices in investment markets, and the proponents of the efficient market tend to base their hypotheses on him.

This principle leads to some questions when considering the recent market events mentioned above.

What was the Rational Economic Man thinking…

When it came to bitcoin?

The price of bitcoin, a form of cryptocurrency, increased roughly 1,750% from the start of 2017 until it peaked on December 18th of that year. It has since lost roughly 80% of its value. If the Rational Economic Man was operating in accordance with tradition and theory, he should have asked himself, “What is the fair market value for Bitcoin?” If all market participants went through that same thought experiment, the efficient market hypothesis would reveal that an equilibrium price for bitcoin should have been reached quickly and efficiently, and volatility should have been muted.

When it came to cannabis stocks?

Less than one year after the peak of bitcoin price, Tilray, a popular cannabis stock, rose 1,160% in a three-month time span from July to September 2018. It has never turned a profit, and its losses accelerated over that same period. What this means is that market participants thought a company became 10 times more valuable in three months despite losing more money. Ideally, the representative of these participants—the Rational Economic Man—would have considered the rationality of those projections and based his investments on that information and knowledge.

When it came to Nvidia?

Nvidia, a U.S.-based company active in the technology industry, is yet another example of the Rational Economic Man’s variation from theory. From January 2015 – October 2018, Nvidia rose 1,330%. It has since lost 40% of its value. This serves as an example of how the mental breakdown of markets can affect all assets, regardless of size. Remember December 2018—the worst December the market has since the Great Depression?

These examples hopefully illustrate that the truth about the Rational Economic Man is a bit messy. And it’s no wonder why. Human beings are flawed. We are emotional. We cannot possibly have every piece of public information stored in our processor (i.e., our brain), and sometimes we even do things that aren’t in our own best interest.

So what can we learn from the Rational Economic Man, even in his flaws?

My tip is this: invest in a way that protects you from yourself. At Warren Averett Asset Management, we structure our portfolios with risk management at the forefront, while always being mindful of the Rational Economic Man. The advantage of protecting yourself from behavioral biases is that you can insulate yourself from buying mispriced securities during the euphoric rise of a security only to get bitten when it comes back down to earth. Hiring investment professionals and focusing on risk management could bring us closer to the textbook version of the Rational Economic Man.

Click here to connect with a Warren Averett Asset Management advisor and learn how we can help you create a customized financial plan.

 

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