"Why Smart People May Persist in Making Stupid Decisions" could be the title of a book about money managers. After all, over the long run, fewer than half of all money managers beat their appropriate benchmarks. It also might apply to pension executives, whose manager selections have continually disappointed.
In fact, it was one of the provocative topics addressed at a two-day seminar at Harvard University last month.
The seminar, "The Behavioral Economics Forum: Scientific Strategies for Financial Decision Making," was sponsored by the Cambridge Center for Behavioral Studies, Cambridge, Mass. Its purpose was to bring to light for money managers and other institutional investors - including pension executives - the latest research linking economics, investing and the behavioral sciences, especially investor psychology.
Many of the sessions demonstrated that investors are not necessarily rational in their investment decisions. Seminar chairman Richard J. Zeckhauser, professor of political economy at the John F. Kennedy School of Government at Harvard, noted there was significant inefficient behavior on the part of individual investors.
He cited three common biases research has demonstrated which affect investor behavior: In one, status quo bias, people tend to stay with the decisions they have made, whether they are good, bad or indifferent. In another, barn door closing, people act after an event has occurred: for example, many individual investors sold stocks after the market had fallen in October 1987. In a third, data packaging, people who buy stocks in November 1995 will think they achieved the 30% plus return the market achieved for the whole year.
David Dreman, chairman and chief investment officer of Dreman Value Advisors, noted that despite studies showing the high error rate of analysts earnings estimates for companies, investors continue to rely on them. Further, even slight earnings surprises can result in major stock price movements. "Current theory assumes that rational decision-makers should learn from past mistakes, but the studies indicate they do not," he noted.
Drazen Prelec, associate professor of management science at the Sloan School, Massachusetts Institute of Technology, said studying how people regard future consequences can detect irrationalities that might lead to exploitable distortions. He noted studies have shown that future gains are discounted more heavily than future losses, and that small gains are discounted more than small losses.
There were several other fascinating presentations, all bearing on what decisions people are likely to make in situations involving possible monetary gains or losses, why they make those decisions, and the implications for investors. In all, this seminar provided the kind of intellectual stimulation beneficial to any money manager or pension executive.
Oh, yes, why do smart people persist? Research suggests, according to John A. Nevin, professor emeritus of psychology at the University of New Hampshire, that people's behavior has momentum analogous to physical momentum. They will continue doing what they have been doing unless compelled to change.