What the Stone Age can teach investors

A brief discussion of some of the behavioural biases that can explain factor premia.

Evolutionary psychology, which attempts to explain mental traits as the products of natural selection, highlights a Stone Age-era mentality that is hardwired into our brains and refected in our behaviour and habits.

This involves people’s tendency to communicate and organise in groups in order to adapt more easily to different environments, on the rationale that it is far less dangerous to be wrong in a group than to be right on one’s own. We can imagine such an approach being taken towards a marauding mammoth thousands of years ago; we believe that individual investors act on similar impulses to follow crowds today.

Research has shown that investment characteristics common to groups of securities, also known as ‘factors’, have historically delivered excess returns over market-cap weighted indices (demonstrating a ‘factor premium’) over the longer term. A dissection of this premium suggests the excess returns are actually the result of the reward for risk, market structures and behavioural drivers, which we outline below.