Does Being Human Hurt Your Investment Results?

The following is a commentary from my friend and fellow coach Fred Taylor:

Does being human hurt your investment returns

Columnist, Morgan Housel had some interesting observations regarding the psychology of investing. As many well know, one of the things that we try to educate investors about is the realization that it is their own human psychology and emotions that are their own worst enemies! Very good for survival of the species — not so good for investors. Some of his thoughts on the subject:

 (Does this sound like you?)

  • You criticize Wall Street for being a casino while checking your portfolio twice a day.
  • You sold your stocks in 2009 because the Fed was printing money. When stocks doubled in value soon after, you blamed it on the Fed printing money.
  • You put $1,000 on a hyped penny stock your brother convinced you is the next Facebook. After losing everything, you tell yourself you were just investing for the entertainment.
  • You call the government irresponsible for running a deficit while simultaneously saddling yourself with an unaffordable mortgage.
  • You buy a stock only because you think it’s cheap. When you realize you were wrong, you decide to hold it because you like the company’s customer service.

“Almost all of us do something similar with our money. We have to believe our decisions make sense. So when faced with a situation that doesn’t make sense, we fool ourselves into believing something else.

Worse, another bias — confirmation bias — causes us to bond with people whose self-delusions look like our own. Those who missed the rally of the last four years are more likely to listen to analysts who forecast another crash. Investors who feel burned by the Fed visit websites that share the same view. Bears listen to fellow bears; bulls listen to fellow bulls.

Before long, you’ve got a trifecta of failure: You make a bad decision, rationalize it by fighting cognitive dissonance and reinforce it with confirmation bias. No wonder the average investor does so poorly.”

Billionaire Ray Dallio (who runs a successful hedge fund) observes (which should be taken as another observation as to why most investors require an investor coach):

“Successful people ask for the criticism of others and consider its merit,”
Dalio writes in his employee handbook. “Remember that your goal is to find the best answer, not to give the best one you have.”

Most investors don’t do this. They assume their opinion (or the opinion of those who agree with them) must be right, and will delude themselves into justifying a belief when shown opposing facts. Dalio doesn’t put up with this behavior — which is part of why he’s a billionaire, and you and I are not.

Psychologists and authors, Tavaris and Aronson have written:
“The brain is designed with blind spots and one of its cleverest tricks is to confer on us the comforting delusion that we, personally, do not have any.”

Unfortunately, we all do and this is one of the important issues for investors that prevents them from having long-term investment success. These emotional “feelings,” of course, are aided and abetted by the media (not to mention the financial services industry which uses investors’ emotions to move products). You must always keep in mind that the media’s first order of business (like a politician’s to get elected) is to drive ratings and it is manias and doom and gloom that drive these ratings, not education or useful information! 

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Here are a few of the more interesting illustrations of predictors predicting and the media publicizing which help to emotionally tie up investors and keep them making decisions that can only be described as harmful. This is fully illustrated by investor behavior over the last four years since the market bottomed back in 2009 from which the S&P 500 has risen around 60%:

1. October 26, 2009 — “The S&P is about 40% overvalued” — Bloomberg.com.

2. January 11, 2010 — “US Stocks Surge Back Toward Bubble Territory” — Businessinsider.com.

3. July 13, 2010 — “On a valuation basis, the S&P 500 remains about 40 percent above historical norms on the basis of normalized earnings.” — Businessinsider.com

4. June 18, 2010 — “Andrew Smithers, an excellent economist based in London, is telling us that we’re way too optimistic, that a fair value for the S&P 500 is actually in the 700 – 750 range. Smithers, therefore, thinks the stock market is about 50 percent overvalued.” SeekingAlpha.com.

The columnist goes on to state that if you only know five things about investing, know these:

”…A handful of cognitive biases explain most of psychology. Likewise, there are a few core principles that explain most of what we need to know about investing.

Here are five that come to mind.

1. Compound interest is what will make you rich. And it takes time.
Warren Buffett is a great investor, but what makes him rich is that he’s been a great investor for two-thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don’t start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That’s unfortunate, and there’s no way to fix it retroactively. It’s a good reminder of how important it is to teach young people to start saving as soon as possible.

2. The single largest variable that affects returns is valuations — and you have no idea what they’ll do.
Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.

The dividend yield we know: It’s currently 2 percent. A reasonable guess of future earnings growth is 5 percent per year. What about the change in earnings multiples? That’s totally unknowable.

Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?

If someone said, “I think most people will be in a 10-percent better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

3. Simple is usually better than smart. 

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97-percent return by the end of 2012. That’s great! And they didn’t need to know a thing about portfolio management or technical analysis, or suffer through a single segment of “The Lighting Round.”

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7 percent of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96 percent total return — still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it’s not like golf: The spectators have a pretty good chance of humbling the pros.

4. The odds of the stock market experiencing high volatility are 100 percent.
Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time — every single time — there’s even a hint of volatility, the same cry is heard from the investing public: “What is going on?!”
Nine times out of 10, the correct answer is the same: Nothing is going on. This is just what stocks do. Since 1900, the S&P 500 has returned about 6 percent per year, but the average difference between any year’s highest close and lowest close is 23 percent. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring. Someone once asked J.P. Morgan what the market will do. “It will fluctuate,” he allegedly said. Truer words have never been spoken.

5. The industry is dominated by cranks, charlatans and salesman.
The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he’ll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood, you stand a high chance of being bamboozled and misled at every corner.

“Everything else is cream cheese.”

Copyright (c) 2013 Frederick C. Taylor All Rights Reserved

Permission granted to share or distribute — with attribution.