(Cover photo source: Glen Carrie
IT’S ALL IN THE MIND……
Reaching a decision to invest one’s capital in any asset is a complex process and we all have our particular theories and methodologies. Some are complex, some academic, some asset specific, and some purely passive.
Investing is a “buying decision” like any other. Typically, these “buying decisions” are the result of a combination of many different prevailing forces. These can include meeting basic needs, convenience, replacement, scarcity, aspirational, price sensitivity, brand recognition, fad or fashion, peer pressure, empathy, indulgence, and fear.
The psychology of consumer behavior is as relevant when investing as it is for any other purchase. There have been many studies on “Cognitive Investing”, all of which seek to analyse the psychological bias experienced by investors in making investment decisions (and often specifically the wrong decisions), and consequent outcomes.
There are a multitude of identifiable biases, which can include overconfidence, arrogance, herd mentality, fear of loss, framing or presentation of facts (‘it looks good and what we are looking for’), narrative fallacy (we like the story), anchor bias (using selective historical data as the reference point), hindsight, and confirmation bias or ignoring contrary information. A less well known bias called representativeness heuristic explains the fallacy of believing that if two objects are similar, then their outcomes are also correlated with each other, and of course we know that is often not the case.
Probably the most frequent behavioral issue when investing is Cognitive Dissonance. This is mental anxiety experienced when a person holds two or more conflicting beliefs at the same time, such as believing new information that is at odds with a pre-existing belief.
There are two things worth observing in this regard:
We all suffer cognitive dissonance or bias.
Experience and knowledge (40 years in my personal case, and an accumulated 200 years, in terms of TEAM investment staff), the management of emotions, and a level of psychological stability, can help to reduce biases, and that alone can help to increase investment returns.
WHERE THINGS CAN GO WRONG
1. HOME BIAS - Investment Managers predominantly invest in companies of their home market. Why?
• They know these companies’ products and are often customers themselves
• They are familiar with current political and economic conditions
• Investment research coverage tends to focus upon the home market
• The companies trade in their portfolio base currency.
This is a fundamental and major issue. There should be a desire to invest in global growth opportunities, irrespective of local economic and market conditions. This provides diversification of various risks including currency, concentration and geographic risks.
The two largest economies in the world are the United States with circa 25% of global GDP, and China with 18/19%. Germany represents around 4.5%, the UK and France approximately 3%. Yet many investment portfolios do not take into account the importance of these weightings.
2. THE BIAS OF BELIEVING HISTORIC RETURNS ARE AN INDICATOR OF FUTURE RETURNS
We are all aware of disclaimers at the bottom of investment documents warning that "Past performance is no guarantee of future results". But that is in fact the basis upon which investment managers are selected, and how portfolios are managed.
The decision facing an investor at the outset in in fact binary. Do something or do nothing. Doing something requires the weighing up of two subsequent, and often conflicting, forces; risk and return. The past, in any isolated period, can be a particularly poor predictor of both.
Volatility, a statistical measure of the dispersion of results over a set period of time, is a frequently used measure of risk, the presumption being that the greater the variance of return over a period, the riskier the future movement in price of the asset.
There are three major issues with this belief:
A. The returns from shares or bonds in general are not ‘normally’ distributed, that is they are not homogenous. Microsoft is not the same as Wells Fargo. The volatility of their returns ignores random walk theory, and their different reactions to externalities. e.g. COVID 19
B. Volatility gives the same weight to both positive and negative outcomes.
C. Past volatility gives no reliable indication about the probability, or size of, possible future outcomes.
3. ANCHOR BIAS
We all know the feeling. We want to buy Microsoft, but the share price has already gone up substantially. We want to buy more Amazon, but the price is higher than that we first paid. The stock market is at an all-time high, so we do not invest. “I’ll just wait for the price to drop, then I’ll buy it.” Two months later it’s at another all-time high. We are fixated with share price highs and lows.
If we decide to buy at an all-time high, we think we have missed the optimal time, or price, to make that investment, so we wait. The price has become the “anchor” point.
This is of course irrational. Yes, share prices move, but how can we possibly predict when or if any “dip” will come in the near term, or how deep that dip will be? Historically, short term dips are often far less pronounced than the gains accumulated during sustained periods of rising prices.
The biggest negative impact of anchor bias is that it restrains us from adding to already successful or profitable investments, and encourages further investment in those where price rises have been slower, or indeed in those assets which have actually fallen in price.
Successful long-term investment requires “running winners and cutting losers”. Rebalancing by taking profits from successful positions to add to the loss makers merely compounds future losses, or limits future gains. This is known as ”disposition effect”, the propensity for investors to relinquish winning positions and maintain losing holdings, a further example of cognitive dissonance. We all like to believe we are intelligent, skillful, diligent, investors and decision makers, so when it does not work out, we are faced with a disconnect
Too many people base their investment decisions on the current share price relative to its trading history. In fact, there is a recognized investment discipline (called Technical Analysis or Chartism) that bases investing on charting share prices.
“Anchoring” a price is not a bad thing but allowing it to bias our thinking is.
4. THE BLAME GAME
Allocation of blame is also an asymmetric pursuit. Individuals who choose to delegate the investment of their money to others are essentially holding an “emotional call option”. If the investment manager performs well, one congratulates oneself for the selection of that manager. If however we experience disappointing investment returns, we absolve ourselves of blame not by taking responsibility for our poor manager selection, but by blaming the investment manager for his performance. We limit the emotional or psychological cost of disappointment because it protects our ego.
The decision to change an under-performing investment manager is emotionally taxing. It forces us to confront our initial decision to appoint the manager in the first place, and why that was wrong. It is far easier to try and demonstrate that things were out of our control or have changed, rather than acknowledge the initial mistake.
In order not to confront this difficult decision, when an investment manager is underperforming, we develop persuasive and compelling reasons for the underperformance. We convince ourselves that it must be something to do with the process, style drift, team changes, the size of assets under management or other myriad reasons.
An investor with an underperforming portfolio has three choices:
Retain confidence in the manager as there has been no change in the underlying philosophy and process. The returns are within expected ranges, given underlying market conditions. Retain the manager.
Acknowledge that although nothing material has changed during the portfolio’s management, a mistake was made in the initial manager selection process, meaning that either strategy or returns have not met expectation. Change the investment manager.
A problem arises within the portfolio due to some kind of change. It may be an unwanted, or unexpected development, which can be linked to the investment process, or portfolio performance. Change the investment manager.
We find it painful from both an emotional, and psychological perspective, to give up on something we’ve worked on for a long time, or to consider that we may have been wrong for a long period of time. It is difficult if we have believed in something or someone for a years, however until we can be honest about how wrong we were in the past, we won’t learn to make better decisions into the future. Our “default” position also encourages us to avoid making decisions on short-term failures, even if that results in much more significant long-term damage.
We need to decide on what to do with those short-term failures in order to enable long-term successes to happen. Because this is what most people are bad at, this is where most of the opportunity lies for improvement.
We all normally base our decisions, including the big life decisions, on the path of least regret. Regret however can only truly be measured over a very long period, a lifetime perhaps. Taking responsibility for changing what is wrong today is the best way of Investing In Your Life for the long term.