Theories on how to play the stock market abound. Buy low, buy companies whose leadership you admire, invest in organizations that reflect your personal values. And don’t count out the ever-popular strategy of throwing darts at the newspaper’s financial pages.
Every investor hopes he or she has figured out how to beat the system and turn a huge profit.
“Perhaps my portfolio is a perfect blend of stocks chosen at the ideal time to bring in enormous returns,” they say wistfully to themselves.
But what if your strategy isn’t determined as much by shrewd analysis (or quality dart throws) as by where you live? Or how old you are? Or if you bought a lottery ticket at the gas station yesterday?
New research by Alok Kumar, assistant professor of finance at the McCombs School of Business, shows these factors–geography, age and even whether or not you gamble–play a key role in how individual investors choose stocks. Kumar and Federal Reserve Board economist George Korniotis studied the demographics and financial transactions of 70,000 anonymous investors and found a person’s behavior in the stock market can be traced back directly to his or her personality and biography.
“There’s no reason to believe that suddenly when you start to invest, you become a different person,” Kumar says.
Sounds simple enough, but Kumar’s research is part of a burgeoning behavioral finance field that is changing the way experts think about financial systems. In the past, economists viewed the market as one massive entity, driven by people motivated solely by the desire to maximize wealth, Kumar says.
But behavioral finance draws on principles from psychology and sociology. This relatively new field asserts that the market consists of thousands of individual players whose distinct backgrounds, beliefs, goals and fears influence their decisions–sometimes to the detriment of their wealth and the health of the market.
Perhaps there is no better proof of this than the recent financial crisis.
“Traditional finance says the behavior of individual investors is cancelled out when you look at the entire market,” Kumar explains. “But the subprime mortgage collapse is a perfect example of the dramatic effect even small entities can have on the market. It shows that often those deviations from expected behavior are not random, but systematic. Many individuals make similar mistakes at the same time, and thus the effect of those mistakes is amplified.”
Rolling the Dice
Evidence of counter-productive stock market behavior is outlined in Kumar’s study, “Who Gambles in the Stock Market?” (forthcoming in the Journal of Finance). He found that the socioeconomic characteristics of people who play state lotteries are very similar to investors who pick stocks that have a lottery quality–high risk with a potential for high return.
But just like playing the lottery, gambling in the stock market usually does not pay off.
“We found that people who took risks in the stock market typically earned 2 to 3 percent less than other investors,” Kumar says.
Kumar also found that people tend to purchase lottery-type stocks more often in a down economy. What’s more, investors who live in regions with a higher concentration of Catholics have a stronger preference for lottery-type stocks, while those in Protestant regions are less drawn to them–a pattern that mirrors ticket-purchasing trends in state lotteries. Those choices generally align with other gambling behavior by the two groups, says Kumar.
Investors who dream about hitting the jackpot aren’t the only people misreading the stock market. In a working paper titled “Long Georgia, Short Colorado? The Geography of Return Predictability,” Kumar shows Americans are perhaps overly enamored of companies in their own backyard, investing the majority of their money in shares of businesses in their home state. So if you live in Texas, you’re more likely to invest in National Instruments, Southwest Airlines or Shell–all headquartered in the Lone Star State–than you are Disney or Viacom, based in California and New York, respectively.
The problem? When a state’s economy starts to go bad, a disproportionate amount of its residents lose wealth because they are overly invested in local companies. Anxious about their finances, those residents start selling their stock, which drives down the price of local stocks, leading them to underperform and lose even more value. Those self-inflicting wounds create a damaging cycle that ultimately drags down a state’s economy.
“The reality is that in any given year, some states are really falling behind, and some are doing really well,” Kumar says. “What we show in this paper is that states that are lagging behind are states in which people are not making good financial decisions. They’re investing, but they’re not doing so in a sophisticated way–their local biases play a major role in this.”
Kumar conducted an experiment that shows savvy investors can actually use this knowledge to profit in the market. Forming hypothetical stock portfolios for all 50 states, based on each state’s homegrown companies, he “invested” in states with depressed economies that were likely to rebound soon. The strategy had an impressive performance, much higher than the return seasoned investors typically hope for, Kumar says.
Experience Doesn’t Always Help
So is anyone immune to this local bias that can be so devastating to a portfolio? Perhaps older investors who have lived through the ups and downs of the market and have learned from years of experience what not to do?
Not exactly, Kumar says. He found that while investors age 65 and above do indeed understand some basics of the market, such as diversifying a portfolio and trading infrequently, they don’t necessarily make good decisions when it comes to picking one stock over another. On the one hand, older investors have years of experience and knowledge gathering. But on the other, people’s ability to make wise decisions can decline with age.
“We wanted to know which effect is stronger: experience, or cognitive aging,” Kumar says. “We discovered that the adverse effects of aging are more powerful than years of knowledge and experience, and that investors typically reach a peak in terms of performance around age 48 to 50. While older investors generally apply common rules of thumb, they don’t do so skillfully or effectively.”
In fact, after adjusting for risk differences on an annual basis, Kumar found that older investors earn 3 percent lower returns than younger investors, and the gap is 5 percent among investors who hold large portfolios.
For seniors trying to grow their retirement funds, or avoid falling victim to numerous financial scams, those statistics are startling. Outgoing Securities and Exchange Commission Chairman Christopher Cox cited Kumar’s study when he testified in a 2007 U.S. Senate hearing on protecting senior citizens from investment fraud.
Noting that Americans age 65 and older hold $15 trillion in assets, Cox explained, “As the baby boomers continue to age, it will be a very short while before the vast majority of the nation’s savings are in the hands of America’s elderly.” Using Kumar’s research to show how seniors are particularly vulnerable, he added, “Investment fraud hurts seniors more than any other group, because when seniors lose their life’s savings, they lack the time to rebuild a nest egg.”
“We are not saying that older investors should stop investing,” Kumar says. “We simply want to point out that they should be aware of the possibility that, along with a decline in physical ability, cognitive ability might decline. This means they might consider working with a financial adviser or trusted family member and be more cautious with their investments. Even just being aware that they are at risk of making poorer choices is hugely important.”
With an ever-increasing percentage of the market inhabited by older investors, Kumar is eager to study this population–and what effect they may have on the stock market–more closely.
Investors Across the Spectrum
The avenues for extending this research seem endless. Kumar hopes to study how political and religious preferences affect economic decisions. For example, do Republicans and Democrats hold different types of stocks? If so, why? Could their choices be connected to their views on the environment, guns, health or other issues? He also wants to examine how behavior patterns might affect the macro-economy, beyond the stock market.
“The bottom line is that how our society behaves ultimately affects financial markets and perhaps even the broader economy,” Kumar says. “In other words, what happens on Main Street has the potential to affect what happens on Wall Street.”
Ten years ago, this was a fairly radical notion, says Kumar. But that reality is becoming harder to ignore.
“Behavioral finance shines a light on market activity that might otherwise seem mysterious or unexplainable when viewed from a traditional economic perspective that assumes people make rational decisions based solely on accumulating wealth,” Kumar says. “It acknowledges that people are also driven by their feelings, dreams and emotions.”
That is to say, we’re all human.