On this episode of The Long View, our guests were Andy Clarke and Nelson Wicas, co-authors of The Architecture of Wealth: The Art and Science of Portfolio Construction. Andy is an investment researcher and writer who has worked at Morningstar and Vanguard. Nelson has developed and managed quantitative equity strategies for more than 30 years. They shared their insights on working with Jack Bogle and decades of research on diversification, indexing, and active management.
Here are a few excerpts from our conversation with Andy and Nelson.
How Behavioral Biases Shape Investment Decisions
Amy Arnott: The book also has a section about behavioral finance. I’m wondering if you could talk a bit about what you think some of the most important insights are from that branch of academic research.
Andy Clarke: Yeah. I guess we think of it in two dimensions. There’s kind of the personal finance angle and then a portfolio management angle. I guess I would say in personal finance, just what we’ve learned about inertia and status quo bias has been huge in corporate retirement plans. As we’ve looked at these innovations—automatic enrollment, default into a target-date retirement fund, and automatic escalation and savings rates—those have put Americans in a much better position to finance their retirement, and they’re capitalizing on this behavioral finance insight into our tendency to stay tied to the status quo.
Nelson Wicas: Look, behavioral finance is a fascinating part of academic finance. It’s been transformative in terms of how people think about the theory, how they think about strategies, and the entire stock market anomalies literature basically was driven by an interest in behavioral bias.
Now, behavioral finance is driven by how people think and decide. It’s drawing heavily upon the psychology literature. When you think about it, there are all these different ways in which people have biases in how they think and decide relative to standard statistical thinking. There’s this certainty principle where basically people take high-probability events and they treat them as if they’re certain. And low-probability events, they treat as being not likely to happen.
Again, sometimes that decision-making, it could be an 85% probability of happening, and they act as if it’s going to happen. And there’s a 30% probability that something is not going to happen, and they choose to act as if it will never happen, so you have that bias. Estimates of probability are also influenced by recency, how recent something has happened, and the future is even just like the past, or this notion of availability. If an event is available to your mind that you know the history of, you then think, “Oh, this future event is just like something that happened in the past.”
Now, where you see this play a big role is, for example, during the Great Depression, people were profoundly influenced by that, and the availability of that experience stayed with investors for decades. After World War II, there were many institutional portfolios where the prudent thing was to stay in bonds and to not invest in stocks because stocks were seen as being terribly risky because, essentially, if you were invested in stocks in 1929, you did not recover the same value that you had in 1929 until 1945.
That sort of availability bias in your thinking led many institutional portfolios, colleges, and other endowments to be heavily weighted toward bonds. And then they missed the huge postwar boom in equities. That kind of bias plays a big role. When it comes to stock-selection models, I teach behavioral finance because it’s used to motivate the literature on the stock market anomalies in history. Often, when you actually are deep in the data, there’s actually often a rational explanation for things.
So, momentum strategies, investing in stocks that have done well in the past, have often been said, “Oh, this is irrational. This is a trend-following event.” You’re basically acting upon information that everybody has, and it pays off for you. But when you look at the data carefully—analysts’ earnings revisions, which is another stock market anomaly—if you look at stocks ranked based on the analyst earnings revision and you look at stocks ranked in momentum, they’re highly correlated. A lot of momentum in practice is the reaction to earnings being revised by analysts. If you combine the two, actually you will see that the stocks that are highly ranked in momentum that continue to pay off are the ones that have subsequent analyst earnings revisions.
The Risks Investors May Be Underestimating
Christine Benz: As you think about investors writ large today and their experiences over the past 15 or 20 years, can you reflect on the biases that we might all have today based on what we’ve gone through as investors?
Clarke: Our recent experience, a bias might be that stocks always recover quickly. There have been long historical periods where stocks have struggled for a decade or more. That could be a bias that affects our behavior.
Wicas: That’s actually a really good example, Andy; because of my age, people seek investment advice and financial planning advice. I actually had a conversation recently, again, with a lady who was 77. She’s fairly well educated, but we were talking about what happens if we have a period of high inflation and how it’s going to crush people’s ability to spend from their portfolios. There is this general sense that we’re not likely to have that kind of experience.
On the other hand, the flip side of it was, we were talking about, well, what would you do? People were saying, “Well, you could sell real estate. Real estate really takes a bath during inflationary periods of time. You’d really have to hang tight on that.” There’s kind of this back and forth where there has been a lot of education that counteracts these biases at the same time. I do think this idea that we’re not going to have an inflation shock is perhaps in people’s thinking.
Valentina Djeljosevic contributed to this article.