What do driverless cars and investing have in common?
It started out as a news story about cars, not investments:
“When a Google self-driving car edged into the middle of a lane at just a bit over 3km/h on Valentine’s Day and hit the side of a passing bus, it was a scrape heard around the world.”
Although the incident was big news in the car industry and at Google, it has no apparent connection to investing. But then the story took a delightful twist:
“The accident illustrates that computers and people make an imperfect combination on the roads. Robots are extremely good at following rules … but they are no better at divining how humans will behave than other humans are.”
Starting to sound familiar? Rather like markets and investments? Here’s the punch line:
“Google’s car calculated that the bus would stop, while the bus driver thought the car would. Google plans to program its vehicles to more deeply understand the behaviour of bus drivers.”
You gotta laugh. Good luck with that one, Mr Google. Will you be programming the bus driver who is texting, or the one who drank too many beers last night, or the one onto his fifth coffee?
Welcome to the world of investing and human behaviour, which is anything but rational.
Former US Secretary of State John Kerry inside one of Google's self-driving cars (Image: U.S. Department of State)
Behavioural finance and the struggle for explanations
Every human emotion plays out when investing, making financial markets unpredictable and struggling for a theory based on scientific evidence. This is especially a problem for superannuation savings, where people may need to live on their money for decades. Loss of assets and income can be very worrying.
Often investment decisions are driven by emotions rather than facts, with common behaviours such as:
- Loss aversion – the desire to avoid the pain of loss by selling below purchase price
- Anchoring – holding fast to past prices or decisions
- Herding – the tendency to follow the crowd in bursts of optimism or pessimism
- Availability bias – the most recent statistic or trend is considered the most relevant
- Mental accounting – the value of money varies with the circumstance
Markets and investors are often irrational and inefficient. They react to short-term news, and tend to overshoot on both the upside and the downside. Ideally, a long-term portfolio such as in a superannuation fund should consider the return on each investment and the risk involved. Investors also need to recognise the emotions and behaviours that will influence expected returns.
Economics as a ‘social science’
Why is investing so imprecise, replete with emotions and strategies with little supporting evidence, when other ‘sciences’ have unified theories? Why does a physicist know how gravity works, an arborist knows how a tree grows and a doctor can treat a patient, while fund managers and economists around the world have different views on markets, stocks and bonds?
Consider physics and Newton’s Third Law of Motion:
“When one body exerts a force on a second body, the second body simultaneously exerts a force equal in magnitude and opposite in direction on the first body.”
That’s a scientific law. There is no equivalent of this certainty in economics. For example, we do not know how the market will react when a central bank reduces interest rates. Maybe it happened because the economy is slowing, which is bad for the markets, and the hoped-for stimulus does not occur. Although economics pretends to be a ‘science’, it is a social science of politics, society, culture and human emotions. And yet our superannuation money depends on it.
It is often said that economics suffers from ‘physics envy’. Economists cannot test a theory in a controlled laboratory-style experiment in the way a physicist or chemist can. Ironically, economists usually earn a lot more than physicists, and are called upon as the experts in almost everything.
Which leaves markets prone to irrational bursts of optimism and pessimism. A Morgan Stanley analyst, Adam Parker, recently advised his clients:
“If the consensus is right that we will chop up and down, then by the time we feel a little better, we should take off risk, not add some. Maybe you should do the opposite of what you think you should do. That’s the new risk management.”
That’s the advice! “Do the opposite of what you think you should do”. Maybe it’s not as crazy as it sounds. The Westpac Consumer Sentiment Index often shows that pessimistic sentiments are followed over the next year by a rising share market, while optimism is followed by a falling market.
Let’s leave the final words to Jack Bogle, Founder of the Vanguard Group, one of the largest fund managers in the world:
“The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in the business, I do not know of anyone who has done it successfully and consistently.”
Good luck with that, Google
I can imagine the driverless car engineers doing what we all do to start a new project, and Googling about human behaviour as they attempted to model how bus drivers might behave. They could do worse than study a good book on behavioural finance to find the full range of human emotions.
What are your thoughts on managing emotions and investments? Let us know in the comments below.
(Feature image: Michael Shick / CC BY-SA 4.0)