Are Traders Dumber than Drooling Dogs?

Salivating Spaniels

Given the ebb and flow of investor sentiment, often for no other apparent reason than the ring of the opening and closing bells of the market, it’s terribly tempting to compare traders to the salivating dogs from Pavlov’s famous experiment.  The dogs, of course, were trained to salivate at the ring of a bell in the expectation of a good meal.

Naturally, this would be demeaning, a gross insult to the intelligence of our canine friends.  Because it turns out that there’s quite a lot of good evidence that humans investors are, despite their superior intellectual capabilities, dumber than drooling dogs.

Reinforcement Learning

Ivan Petrovich Pavlov’s experiments were amongst the first in modern psychology, and involved the discovery that you could train dogs through reinforcement.  His dogs were taught to associate a ringing bell with a good meal, which eventually led them into salivating in the expectation of food at the sound of the bell in the absence of anything edible.  Psychology has long since abandoned a simple model of reinforcement learning, recognising that people are driven by a whole set of complex beliefs and behavioral biases rather than simple stimulus-response models.  

Still, there’s a suspicion that, when we’re faced with complex situations characterised by uncertainty, we fall back on simpler models of learning to create the beliefs that drive our behaviour.  Investing in the stockmarket certainly qualifies in this regard, uncertainty is pretty much everywhere, all the time: even if people choose not to recognise this for long periods.

Pride and Regret

Initial studies of investment behaviour identified standard behavioral biases as causes of irrational risk seeking and avoidance: overconfidence drives over-trading and a fear of regret drives an unwillingness to sell loser stocks, and so on.  This is the stock in trade of behavioral finance.

So, for example, Odean, et al. in Once Burned, Twice Shy find that the way investors handle stock repurchases is profoundly irrational.  They purchase stocks they previously sold for a profit at a lower price, but not those they sold at a loss.  Meanwhile they’ll purchase more shares of a stock they hold at a lower price, but not at a higher one.  The researchers attribute this behaviour to avoidance of regret – averaging down lowers the break-even price, while not buying back at a higher price allows the investor to avoid regret at their previous actions. None of this behaviour improves investor returns.  However, there’s a suspicion that these types of explanations may be more complex than required.  To understand this we need to revisit Pavlov style reinforcement learning.

Depression Babies

There’s considerable evidence that the experience of your upbringing influences the way that you invest.  Malmendier and Nagel in Depression Babies: Do Macroeconomic Experiences Affect  Risk-Taking? showed that people who experienced low stock market returns throughout their lives were less willing to take on risk and participate in markets.  In reverse people who’ve experienced low returns from bonds are equally unwilling to invest in fixed income.  The research also shows that actual experience matters much more than book learning: people are unable to abstract away from their own experiences, no matter how atypical or lucky.  Moreover, the researchers argue:

“We show that higher experienced stock returns are associated with more optimistic beliefs about future stock returns. This suggests that the experience effects could be the result of individuals’ attempts to learn from their experiences, albeit not by using all “available” historical data, as in standard rational and boundedly rational learning models, but by focusing on their life-time experiences.”

If so then apparently irrational behaviour isn’t caused by some invisible set of biases encoded into the brain, but is caused by reinforcement learning. When whole groups of people grow up under the same general conditions – a Great Depression or a Goldilocks Era – they all exhibit the same sorts of bias.

Power Law of Practice

Now if investors are drooling dogs and not biased bozos there are a few clues we can look for.  High among these would be evidence of the Power Law of Practice: an overly complex way of saying that people should become better at investing the more they do it. They should improve as they learn what works and what doesn’t and the people who aren’t any good should drop out, leading to a survivorship effect where the only people left standing are either good investors or completely and utterly deluded (see Don’t Lose Money in the Stupid Corner).

These effects are difficult to discern because we have new entrants to the market all the time but research by Choi and colleagues suggests that they’re observable: basically, if you’re skilful or lucky enough to get high returns or low volatility in your portfolio you’ll continue to invest.  They explain:

“The observed patterns are explained by a naïve reinforcement learning heuristic: assets in which one has personally experienced success are expected to be successful in the future.  Consistent with reinforcement learning, we also find evidence for the Power Law of Practice: return chasing and volatility avoidance decline with age as a large stock of experience is accumulated, though they remain present throughout the lifecycle.”

Learning Reinforcement Bias

As you might expect, given the vast range of biases we’ve covered in the past, all of this rampant drooling, tail-wagging behaviour has led to the proposal for yet another one: learning reinforcement bias.  De, et al also propose that the biggest driver of future investor behaviour is their past experiences of losses or gains, but it’s not the size of these that matter but whether they’re profitable or not: so, success increases an investor’s wealth, which increases their appetite for risk taking, showing up in greater trading volumes, and so on.

However, this comes at a cost: the investors in their research collectively passed $2.31 billion over to the securities industry during the sample period.  They suggest the reason for this is that: 

“Individual investors who are relatively less influenced by the reinforcement learning bias are more successful than others. If institutional investors are rational, or at least less biassed than individual investors, then reinforcement learning bias could provide an explanation for the wealth transfer observed in our case.”

Which helps explains why the securities industry is hugely profitable and traders, generally, aren't. The bell, and most of the experience, is on the side of the professionals and most of the drooling is on the side of the traders.

Overtrading is not Irrational

This idea, that traders are driven by a combination of their own skill, or lack of it, and the random luck of their experiences is expounded upon in some fascinating research by Juhani Linnainmaa: Why Do (Some) Households Trade So Much?  The answer proposed is a bit surprising: people don’t trade too much because they’re irrational and overconfident but because they’re rational and trying to figure out whether they’re any good as investors or not.  It's learning reinforcement and not behavioral bias.  As he explains:

“Investors learn from their own experiences, and the resulting evolution of beliefs is an important driver of investor behavior.”

Which adds to the evidence that the longer people trade the better they should become, as they build up greater stocks of expertise.  Which is exactly the result uncovered  by Seru, Shumway and Stoffman who showed that greater experience  reduces the propensity of investors to fall for the disposition effect (see Disposed to Lose Money) – selling winners and keeping losers; to boost pride and reduce regret – and that trading style changes with age, moving towards larger stocks and a greater emphasis on diversification.  Encouragingly for all those investors suffering today:

“Learning is particularly strong among specific groups of investors, including unsophisticated investors, investors who start out earning consistently poor returns, and females. Investors also learn faster during general market downturns.” (my bold)

Essentially losing money when you start out gives you a better grounding than making it: you learn the proper lessons.  And, as we’ve seen before, being female gives you a head start (see Investors, Embrace Your Feminine Side).

All of which suggests that although we’re mostly drooling dogs when it comes to learning about investing, we’d be better off finding out a bit more from books and a bit less from experience.  The trouble with experience is that it’s an expensive way of learning: although you won’t find many people in the securities industry telling you that, as they happily ring the bells and rake in your dollars. 

Related articles: BF Skinner's Stockmarket Slot Machines, Disposed to Lose Money, Regret, Investor Decisions - Experience Is Not Enough, Don’t Lose Money in the Stupid Corner, Investors, Embrace Your Feminine Side