What Did The Bear Do To Your Brain?

April 22, 2009

As market volatility increases, four 'behavioral traps' move into the forefront. Here are some tips on how to avoid these mental minefields. 

 

"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble ... give way to hope, fear and greed."

—Benjamin Graham

The terms investor psychology, behavioral finance and neuroeconomics have become synonymous with research conducted on how individuals make decisions regarding money.

Since the 1970s, this field of study has continued to gain legitimacy, culminating in 2002 when a Nobel Prize was awarded to psychologist Daniel Kahneman and experimental economist Vernon Smith for their landmark research.

The work of Kahneman and others provide empirical support to the notion that individual behavior does not align with traditional simplistic economic theories on financial decision making.

Traditional economic theories falsely assume that people rationally weigh costs and benefits to make the most economically rewarding decision. Behaviorist studies confirm that we often make financial decisions that do not yield the largest economic gains, appropriately account for risks or accurately assess probabilities.

Researchers have categorized these "behavioral traps" into various groups and subgroups. In particular, four of these seem most immediately relevant to current times and conditions:

  • Risk perceptions
  • Mental accounting issues
  • Anchoring tendencies
  • The gambler's fallacy

Turning our attention to understanding and identifying each could prove quite beneficial in these volatile and often confusing times. 

1) Risk Perceptions

One of the greatest challenges that investors face is constructing an investment strategy that gets the investor where they want to go without taking on too much risk.

Studies have shown that tolerance for risk can change depending on a person's mood. If you are feeling happy, you may feel more positive about taking on risk; if you are feeling negative, you may be inclined to avoid risk. Intense positive or negative emotions can have a huge effect on our attitudes about financial risk.

But we have a difficult time quantifying risks and understanding the difference between rewarded risk and unrewarded risks for other reasons. One of the most common behavioral traps along these lines is called familiarity bias. This refers to investors who often falsely believe that a fund focusing on an asset class or sector they work with or know about on a personal level is less risky than the market as a whole.

Research shows that often this bias persists even after numerous companies, believed to be solid, have disappeared completely. Rationally, we should all agree that the likelihood of the entire stock market going to zero is lower than that of one company or industry doing so. Regardless, investors fail to understand the risk they face by not diversifying.

Often, investors get confused about which risks they should expect to be rewarded for—this is the reason that casinos and lotteries exist and thrive. A rational analysis of risk would include calculating expected payoffs before choosing among endeavors. Clearly, in the world of gambling and lotteries, expected payoffs are negative. In the market, however, trying to make these calculations is complicated and is often overlooked by investors. A diversified portfolio should present a positive expected return given enough time, rewarding investors for the risk taken.

When investors concentrate their portfolios in too few securities, industries, asset classes or countries, they take on additional risk without increasing expected returns.

It's also just natural for investors to react more severely to short-term price declines than they do to the long-term wealth-eroding effects of inflation. This occurs even though short-term price declines should be viewed as temporary because the inflationary effects are veiled and occur over a longer period of time, making the losses less noticeable. The faster the drop the more severe is our desire to react to it. These behaviors are seen in the market by tracking individual investor cash flows and investor sentiment surveys. 

 

 

Investor sentiment often is positive at highs and negative at lows. Many investors engage in a constant battle of pride, regret, fear and overconfidence which leads them down various roads to poor decision making. It's important to note that while all of these reactions are normal, they do not translate to more wealth if acted upon unrestrained. We have to understand that the odds of a particular endeavor do not change because of how we feel about the next trial or what happened to us in the previous trial. The gambler's odds do not change based on the result of his last toss of the dice or the amount he won or lost on that last toss.

Our minds may lead us to believe that we had something to do with the process in the past and that we can affect or predict the outcome going forward. This is all normal behavior that should be kept in check in order to emerge successfully from market extremes. The key is to avoid changing our risk exposures too often and for the wrong reasons.

It is best to avoid making large financial decisions while you are in an extreme emotional state (either positive or negative). When it comes to investing, written investment plans built during a calm emotional state with the assistance of a qualified adviser, who will hold you accountable, can help counter emotion-based decision making.

Plans should be made, reviewed and periodically updated with an awareness of your emotional state and they should include your financial values. Your financial values tend to be long term and rarely change, so they act as a better filter to screen financial decisions. Also, your values tend to act as a better adhesive when examining the merits of sticking to your written plans. Assessing risk tolerance periodically and considering how market and life circumstances affect you over the long run should help as well.

Investment policy documents capture your specific goals, risk tolerance assessment and financial objectives including your financial values, and provide a written analysis of the investment philosophy being implemented. The documents should outline how investment decisions are made so that there are few surprises when we head into various market conditions.

2) Mental Accounting Issues

Mental accounting is the tendency for individuals to organize and file decisions separately. You can use a mental accounting system similar to a file cabinet when tracking investment decisions. The folder contains the costs and benefits associated with a particular decision. Once an outcome is assigned to a mental folder, it is difficult to view that outcome in any other way.

For example, a person may be saving to buy a vacation home in five years in one account that earns 4%, while paying 9% on a three-year car loan. Because each goal has been classified separately the person does not see the flaw with this strategy.

You can put labels on different monies—dirty money, easy money, free money, sacred money—and treat these pools of money differently. In an economic sense, money inherited from a respected family member should be handled the same way as money received from a tax refund. Yet people are more likely to invest the inherited money in one way, usually conservatively, while the tax refund is likely to be spent or invested in another way.

Mental accounting also causes investors to view each of their portfolio holdings in isolation rather than within a total portfolio context. This practice can be very expensive over a lifetime of financial decision making because it causes investors to miss the point of modern portfolio theory, which is to view all of your assets and liabilities in combination rather than in isolation. Viewing each investment separately rather than using a portfolio and total net worth approach limits investors' ability to minimize risk and maximize return.

 

 

Investors should avoid focusing on the performance of one investment or one asset class in isolation. For example, if we have a combination of fixed income and equities, it is better for us to focus on the combined performance of the entire portfolio over a long period of time. This also applies to each account; we should focus on the performance of all our accounts combined. Further, investors should include all of their assets (both liquid and less liquid assets) and the effect on their total net worth over time rather than the amount of decline experienced over a very short period of time in one section of their net worth (like the piece invested in the market) or one subasset class (like emerging markets). Diversification needs time to work and it does not work perfectly in every one-year (or less) time period.

However, it works well over long periods of time so investors should stay focused on the bigger picture when going through difficult markets. Your investment strategy is likely the result of a combination of short-, intermediate- and long-term goals. It may be tough to keep that in mind when investments are mixed in a way that combines all of those goals.

3) Anchoring Tendencies

Investors often tend to latch on to a specific reference point when making decisions even though the reference point has no relevance. For example, investors have the tendency to use the original purchase price of a fund as a reference point when making future decisions about selling or holding the fund. They fail to realize that the market and the fund do not care what the investor paid for it in the past as it has little relevance to the real value now.

During declining markets, investors tend to anchor on the peak value their portfolio reached. Investment declines are calculated from the peak point, not from a specific time period in the past. Anchoring in this way may cause severe emotional reactions.

The best way for investors to counter this behavior is to inspect portfolio values over specific longer-term time intervals instead of high and low points. Rather than checking portfolios daily, weekly or even monthly, investors should make an effort to wait for their statements to arrive. Research has shown that individuals who check their accounts more frequently tend to trade more frequently and also tend to generate lower returns.

It is best to examine the returns of an investment strategy over the past several years and where possible, over an investment lifetime. For investors that have not been investing for long it is worth examining the long-term historical data on diversified portfolios.

Another strategy is to examine gains or losses in the context of total net worth changes over longer periods of time. For example, a person who has seen their $500,000 portfolio decline 30% from the high point (a $150,000 decline) may be prone to panic by focusing on a loss of $150,000. If their premarket decline total net worth was $1,000,000 before the market decline, the percentage decline is cut in half. Also, if they looked at the change in their total net worth over the last five to 10 years, they may find losses are even less severe than previously thought.

4) Gambler's Fallacy (Law Of Small Numbers)

Research shows that people place too much emphasis on a few witnessed observations when making predictions about future outcomes. We believe trends are apparent where they do not exist, and this leads to chasing performance among other poor investment decisions. Our minds are adapted to making quick reflexive decisions because for most of our existence we had to avoid dangers and seek opportunities for food with little time for calculation.

In any random string of events guided by probability, you will see many streaks over short intervals. Statisticians explain that the oddity is when you do not see streaks occur. It is over large numbers of trials that results gravitate toward the expected probability, with many streaks and breaks from the long-term odds occurring over short intervals.

 

In areas such as investing we are prone to make a different mistake because we believe that skill is involved. We tend to follow the trend. When a particular money manager or strategy outperforms the stock market, we are tempted to place our money with that manager or into that strategy thinking that the trend of outperformance will continue.

When friends, neighbors, family members, media persons or investment managers come to you bragging about their brilliant foresight in predicting this recent downturn, smile and then politely change the topic of conversation. Research shows that those who attempt to market-time do poorly, so let's examine why their overconfidence should be ignored.

These people will question the merits of staying the course and attempt to make you feel foolish for doing so because they believe their getting out of the market was a skillful move. By the way, their telling you this is the result of another bias people experience when making decisions; they do not like to be alone in their views. In these types of situations, treat them as you would a neighbor who won the lottery. You may be happy for them and tempted to buy a ticket yourself. But you would not purchase lottery tickets with your life savings because you would realize they were just lucky, not skilled in lottery number selection.

In the same way, investors should not abandon a sound investment strategy because they feel the market decline was predictable. We are excellent "deletion" creatures who make wrong predictions frequently yet don't realize it because we quickly delete those wrong predictions from our memories. Only the past inclinations we had that become a reality rise to the forefront of our minds, leading us to believe we are right more than we really are.

Lastly, we need to consider what academics call survivorship bias when we think predicting markets is easy. For example, you only hear from the neighbor who won the lottery—not the overwhelming majority of those neighbors who lost. The same is true of those who happen to call the market correctly on a specific occasion, including ourselves.

Let's look at one last illustration demonstrating how winners will always emerge by pure chance without a pattern of consistency being present. If we filled a stadium with 10,000 coin flippers and conducted a series of 10 flips (think of 10 years of market returns), with those getting heads staying in the contest (winners or market beaters) and those getting tails getting dropped from the contest.

In the first flip we would expect 5,000 people to remain in the contest; the second flip 2,500 and so on. After the 10th flip we would expect close to 10 people to remain who have flipped 10 heads in a row. It would be false to assume these people have skill in coin tossing. However, if they were investors, the press would herald these 10 people as market gurus; these lucky individuals may even start money management firms and write columns in Forbes magazine attracting large amounts of investor money.

Hopefully, we all see that it would not be wise to invest our money in a strategy put forward by these 10 coin flippers in spite of past success. Remember, over a one-year period (or the first flip) we would expect 5,000 coin flippers to win. There is a high probability that a large number of people avoided some of the market decline. The problem is we would expect that by chance, and those people now have to know when to get back in the market in order to win over the long run.

Further, they have to be able to repeat this process over time. We should no more listen to those lucky coin flippers than our friends or opportunistic money managers who tell us they avoided the down market last year.


Kenneth Smith is chief executive of Seattle-based Empirical Wealth Management. He welcomes suggestions and comments for future columns at

\n [email protected]

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