November 2016 IssueLong scroll reading

Always Late to the Party, or Understanding Investment Biases

By Robert Cochran

It’s a funny thing, momentum. Some investments can do nothing at all for years, then suddenly produce very strong performance numbers. At the same time, other investments will have years of consistent out-performance and then, seemingly overnight, crash and burn. More often than not, these behaviors happen to individual stocks and sector funds, although some diversified funds fall victim to similar behaviors. Investors themselves often act in ways that lead to their own crashing and burning, causing them to think they are always late to the party, or that the punchbowl was taken away just before they arrived.

Behavioral finance is the study of individual investor behavioral biases, and there is a lot of material readily available to those interested in the subject.

Some biases are cognitive, meaning they are based on so-called rules of thumb that may or may not be factual. Here are a few of the most common.

  • The Bandwagon Effect: John Templeton was one of the world’s greatest value investors, suggesting that the time to buy was when blood was running in the streets, when everyone was shouting “Sell, Sell!” Resisting the crowd of lemmings, especially when you are standing in their path, is darned hard for many individual investors.
  • Negativity Bias: Liz Ann Sonders has termed the 2009-2016 (and still going) period the most unloved bull market in history. How many people bailed out of the market in late 2008 and early 2009 and have been sitting on the sidelines since? They have missed one of the biggest recoveries ever, and will likely never recoup their losses. But they remain stuck in cash, fearing another imminent crash, or paralyzed because of political bias, or both.
  • Confirmation Bias: Virtually all of us are guilty of this to some extent. We latch on to views that are similar to our own, and we ignore or avoid those with which we disagree. Confirmation bias can manifest itself in the television programs we watch, the radio programs we like, how we view the economy, the politicians we support and those we dislike, and for sure how we invest.
  • Status-Quo Bias: Those of us who have pets know how they are creatures of habit. We get a kick out of watching them follow the same behavior patterns over and over again. But investors are also creatures of habit. We tend to have a very small group of funds that we use again and again, rather than looking at new ideas that might offer greater diversification, lower expenses, less volatility, etc.

Emotional biases can be even more ingrained, and they are harder for us to overcome.

  • Loss-Aversion Bias: We have all experienced this bias, most often in the form of a stock we purchased that was a “no brainer” great idea. Unbelievably, the stock tanked and we continued to hang on, not because we had realistic expectations it would recover. After all, if we hold the stock, we don’t have to admit to ourselves it is a loser. In the meantime, the value continues to decline, robbing us of the opportunity to re-deploy proceeds into something better. Experience can play a huge part here, as psychologists agree that people remember losses “forever”, while they tend to forget the good times.
  • Misplaced Expertise Bias: Someone has worked in the high-tech industry and thus believes they have greater ability to pick tech stocks than professional traders/investors. Or they have an uncle that worked in the pharmaceutical industry, who loves telling everyone what great investing ideas he has. More often than not, the picks turn out to be disastrous.
  • Mental Accounting Bias: For some people, an investment inherited from their parents is sacrosanct – not to be touched, no matter what. People can be emotionally tied to certain investments. If it was a gift, or if it was inherited, it is looked at differently.
  • Hindsight Bias: We have all said or thought “I knew that would happen.” It is a way for investors to think something was really more predictable than it actually was. So-called experts will look back at the com bubble and point to rather trivial things at the time and suggest they were predictors of trouble. In truth, if something was indeed that obvious, more investors would have avoided the bubble. Thinking we can predict the future (we are smart people, after all), is akin to fortune telling. But, of course, we would never use that term to describe our predictions.

These biases can affect individual and professional investors. Professionals are more likely to have access to tools that will help them recognize and limit their biases, but they are there nonetheless. The important thing is to recognize our biases and try to minimize their impact on our actions.

Here are some ways to adjust your behavior:

  1. Stop thinking you can outsmart the markets. Forget trading. Trade less, and invest more. Don’t think you can beat computer programs and institutions. Lengthen your time horizon.
  2. Set rules for yourself. When you buy a stock or ETF, set both high and low targets at which you will sell. If nothing else, set a trailing stop that will lock in gains. Don’t allow your emotions to break these rules.
  3. Don’t allow noise to affect your investment decisions. Remember that broadcast media is almost forced to hype things to the extreme to generate advertising revenue. The wilder their predictions and the louder their shouting matches, the greater their number of viewers.
  4. If you think you have discovered a trend, know that the market already identified it long before you did. When an unloved sector suddenly starts to get attention from pundits, it has probably already produced significant gains.
  5. Establish an overall investment allocation that is in line with your cash flow needs, your risk tolerance (sleep factor), and your long-term goals. Be realistic with each of these factors. Then if you have the urge to sell out of stocks every time there is a correction, or if you want to increase your stock allocation when the markets are doing well, don’t do it. Remind yourself that the allocation is there for specific reasons.
  6. Re-balance on a regular basis. This may be as important as anything, and it may force you to capture gains from the best performers, and move dollars to the unloved.

While these adjustments may go against a number of your biases, they might let you arrive at the party before anyone else and have first dibs at the punch bowl.

This entry was posted in BobC on by .

About Robert Cochran

Robert Cochran is the lead portfolio manager, Chief Compliance Officer, and a principal of PDS Planning in Columbus, Ohio and a member of the Board of Directors of Mutual Fund Observer, Inc. Bob’s been a financial professional for the past 31 years, writes thoughtfully and well, and had a stint teaching at Humboldt State in Arcata, a lovely town in northern California. He also serves on the Board for the Columbus Symphony (and was formerly their principal bassoonist) and Neighborhood Services, Inc., one of Ohio’s oldest food banks.