Wednesday, July 13, 2005

John Maynard Keynes has a Posse

I love stock markets because they are a great laboratory for studying human nature. They show us that people can behave irrationally even when they have incentives not to. In investing, unlike in most areas of life, there's a neat and incontrovertible measure of performance - share returns - against which we can judge rationality or irrationality.
So, here are some lessons of stock markets that might have a wider application:

1. Groups perform worse than individuals; Brad Barber (all of whose work is fascinating) has found that investment clubs under-perform individual investors (pdf).

2. People over-react to long streams of information (pdf).

3. People are overly optimistic about things they believe (wrongly) they know well

4. Expert opinion herds together (pdf) professional investors buy the same stocks as each other, regardless of their real merits.

5. What people choose is strongly influenced by the way the choice is presented, rather than by purely rational considerations. Richard Thaler (whose work is compulsory reading) and Shlomo Benartzi have found that even highly qualified professionals choose a pension fund weighted towards bonds if they are offered lots of bond funds, but an equity-weighted pension if they are offered lots of equity funds (pdf).
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