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Most of us know we are not perfectly rational investors. But we may be irrational in different ways.
A study simulating investor behaviour was recently published in the Journal of Behavioral Finance where the authors trained artificial investors with different limitations or biases and then compared them to a fully rational investor benchmark.
We may not map neatly into any one of the five archetypes they presented. Rather, we may exhibit traits from a few. Nonetheless, they may offer us some insight into the mistakes we are prone to make and how they may cost us.
The practical shortcutter (technical term: Bounded rationality)
This investor understands roughly what should be done but has limited time, information or processing power. Therefore, they rely on shortcuts and settle for “good enough” decisions rather than endlessly trying to optimize.
These investors generally move in the same direction as the rational investor but took smaller positions. It’s like they saw the optimal path forward but didn’t fully commit. As their decisions in the simulation became more random, their performance worsened. Interestingly, they sometimes helped the overall market by providing liquidity even though they did not benefit from that liquidity themselves.
Simplification may help this type of investor. Defining their portfolio rules more clearly and trying to avoid real-time judgment can help them be more proactive as opposed to reactive.
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The short-term reactor (Myopia)
Speaking of reactive, the short-term reactor gives way too much weight to what is happening in the moment. A temporary decline feels more urgent than a long-term plan so they react to recent price trends and trade frequently.
When the researchers simulated a temporary market shock followed by a recovery, myopic investors sold as prices fell. Rational investors were more willing to hold, or even buy, and did better when prices recovered.
Myopic investors had lower average profits and were pretty consistent in their results as their shorter holding periods limited both the damage and the upside.
Looking at the markets less would help these investors as a long-term portfolio with higher potential return comes with short-term volatility that cannot be predicted in advance.
The break-even chaser (Prospect bias)
This investor is cautious when ahead but becomes a gambler when facing losses.
Winners are sold quickly but losing positions are held or even doubled-down in the hopes of getting back to even. The initial purchase price becomes an emotional reference point even though a stock does not care what price you bought it at.
These investors produced lower average profits and wider performance swings but with modest gains paired with occasional large losses.
A useful question to ask yourself if you find yourself mimicking this behaviour is whether or not you would buy this investment today if you did not already own it.
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The best-case investor (Optimism bias)
This investor overestimates the chance of favourable outcomes. Confidence leads to larger positions and more aggressive trades.
The optimistic investor had the widest range of outcomes. They still earned a positive average return but the problem was in how unpredictable those results were. Position limits may help optimistic investors who have a tendency to create large, concentrated positions.
The worst-case investor (Pessimism bias)
As opposed to the best-case investor, this investor gives too much weight to what could possibly go wrong. As a result, they trade infrequently, hold small positions when they do and tend to avoid severe losses. But they also miss out on the market’s upside and end up with lower than average profits.
While their strategy of avoiding more of the large losses may feel good at times, it comes with the enormous opportunity cost of being chronically underinvested.
This type of investor might benefit from embracing multilevel diversification as a means to help mitigate their perceived exposure to all the things they are worried about.
Overall the simulations helped tease apart the different ways in which investor irrationality can manifest. Some investors lose by doing too much. Some lose by doing too little. But instead of lumping underperformance into a general category of being irrational, we have some insights that might help us recognize a little bit more of who we are as investors individually.
In the end, this falls under some timeless investing wisdom: Investor, know thyself.
Preet Banerjee is the creator of YourMoneyDegree.com, a financial literacy program with an AI companion app.
