Investors’ biases: not as new as you think

By Dr Vasileios Kallinterakis from Issue 15

The technological advances in investing during the past few decades have been truly phenomenal. From the early days of online trading in the 1990s to modern-day AI trading bots, the world has witnessed a growing sophistication in the tools available to investors that has rendered trading easier than ever. Easier, however, need not necessarily imply error-free. 

Modern-day investors project biases in their decisions, amplifying irrationality in trading dynamics, which culminates in the onset of spectacular episodes (from the cryptocurrency-hype to meme stock frenzies). Every time such an episode unfolds, the media are eager to lament it as a reflection of investors’ irrational exuberance or animal instincts; the popular finance literature further fuels this narrative with sensational stories, while the finance self-help literature aims for a more ‘popularised’ presentation of the psychological reasons prompting these trading behaviours. In the end, human irrationality is blamed and the investment losses from those episodes are viewed as a lesson to deter the repetition of such behaviour in the future.  

Except, financial history has little evidence to show in favour of such deterrence. Alas, from the earliest capital markets to the modern-day ones, the world keeps bearing witness to financial episodes that create immense publicity and generate formidable losses. These episodes never seem to abate, therefore casting doubt over whether the losses suffered by investors ever produced a learning effect of any significance. This suggests that we repeat our mistakes not simply because of irrationality per se (after all, errors in judgement are part and parcel of human nature), but also because we don’t learn from them.  

Although failures in learning would be expected to eventually diminish over time (repetition of an error should, in theory, grant some measure of learning to those committing it), this doesn’t seem to be the case in financial history. Perhaps no other book exemplifies this better than Confusion of Confusions. Written in 1688 by the Sephardi merchant Joseph de la Vega, it provides a description of investment life in the 17th-century Amsterdam stock exchange, showcasing that investors’ trades projected behavioural biases (e.g. herding, loss-aversion, sentiment trading) that were first systemised and studied by behavioural finance researchers in the last quarter of the 20th century. Although this qualifies Confusion of Confusions as the first-ever behavioural finance treatise, a scholarly review of Vega’s book demonstrates this never really took place. 

My book, Dawn of Behavioural Finance, 1688, addresses this by performing an analysis of Vega’s book based on the behavioural finance paradigm. Presenting a critical discussion of several concepts from the behavioural finance literature evident in Confusion of Confusions, I demonstrate for the first time that behavioural finance needs to be backdated to the 17th century, and that Vega constitutes its precursor. The fact that Dutch investors in the 1680s are shown by Vega to be subject to the very same biases in their trades as 21st century ones implies that behavioural forces in investment decisions are truly unremarkable; at the very least, it confirms that ‘nothing is new under the sun’. Further, the fact that the same biased trading patterns are observed over three centuries shows that we’re not as evolved as we think.  

One possibility is that we fail to learn from our mistakes due to biases distorting the updating of our beliefs/self-assessment; overconfidence, for example, makes us attribute our failures to others. Sometimes, we repeat mistakes because we forget when we first made them (if they took place a very long time ago), or because we believe that ‘this time it is different’; social influence can also motivate us to repeat past mistakes (due to conformity with social norms, or fear of missing out). We’re unlikely to learn from past mistakes if they were committed by others (the pain of loss is theirs, not ours). In addition, we fail to learn because we may not be bothered to; after all, learning involves effort (e.g. in terms of time and thinking cost) – and this may lead the cost of effort to exceed the expected benefit. 

The fact that the mistakes investors make in the 2020s were documented by Vega in the 1680s demonstrates the need for a shift in the behavioural finance debate. What good is it arguing that a bias exists in one’s behaviour, when the same bias was recorded over 300 years ago? To the extent that we keep reproducing the same mistakes over the centuries, this suggests the need for educating investors on how to engage with their mistakes, by demonstrating to investors that errors are normal, and help them discover/experiment with different ways to learn from them. Only by doing so can we effectively move from a culture of regret (keen on identifying judgement-errors) to a culture of change (proposing tools on how to learn from those errors).