“The four most dangerous words in investing are ‘This time it’s different.’”
According to the 2016 Dalbar Quantitative Analysis of Investor Behavior (QAIB), in 2015, the average equity mutual fund investor underperformed the S&P 500 by a margin of 3.66%. This was not a one-year aberration but rather a long term trend. The 20-year annualized S&P return was 8.19% compared with just 4.67% annualized return for the average equity mutual fund investor — a gap of 3.52%.
If you invested $100,000 in the S&P in 1996 and made no additions for 20 years, your balance in 2015 would be $482,772. The average mutual fund investor, however, would have only grown to $249,140 — a difference of $233,632.
What causes such a performance discrepancy?
According to decades of research by behavioral finance experts, this underperformance is caused by a variety of factors including poor timing, psychological traps and misconceptions. I’m no behavioral scientist but in my experience, most underperformance is due to the primal emotions of fear and greed, and the flames of those emotions are fanned by the sales and marketing efforts of financial product manufacturers and their brokerage agents. In my experience, market timing losses are not always caused by investors. Often, it’s the intervention of a brokerage sales call or a compelling argument of a media talking head that prompts the ill-timed decision. Brokers sell what’s easiest to sell and what’s easiest to sell is what has been doing well, not what will necessarily do well.
I’m adamantly opposed to market timing strategies. I believe there are far more reliable and effective methods of pursuing enhanced performance. I’ll discuss them in a later chapter.
Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioral finance recognizes that people employ imperfect rules of thumb to process data which induces biases in their beliefs and predisposes them to commit errors.
Economists typically model behavior in terms of rational individual decision-makers who make optimal use of all available information, but there is ample evidence that the rationality assumption is unrealistic. Behavioral finance studies the nature and quality of financial choices made by individuals and examines the consequences. Investment portfolios are frequently distorted, with consequent excess volatility in stock and bond prices. Examples include the stock market crash of 1987, the bubble in Japan during the 1980s, the demise of Long-Term Capital Management, the Asian crisis of 1997, the dot-com bubble, and the financial crisis of 2008. It’s problematical to discuss these dramatic episodes without reference to investor psychology.
What follows is a discussion of some of the various behaviors and biases investors exhibit that lead to poor investment results — a price paid for irrationalities. Perhaps you will recognize some of them. As you do, keep in mind the old Wall Street adage: Two factors move the market — fear and greed. Fear moves the market down; greed moves the market up.
Overestimating or exaggerating one’s ability to successfully perform a particular task is called overconfidence. Investors who enjoy some success trading stocks may begin to think they have the market figured out. They may even delude themselves in believing that every trade they make will lead to more profits and so they ignore the inherent risk of trading…which leads to more trading and more risk. People also tend to remember successes but not their failures, thereby unjustifiably increasing their confidence.
Investors with an overconfidence bias overestimate the accuracy of their forecasts. This stems partly from the illusion of knowledge. The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations. Overconfidence is particularly seductive when people think they have special information or experience that persuades them to think they have an investment edge. In reality, however, most of the so-called sophisticated and knowledgeable investors do not outperform the market consistently.
Overconfidence can also lead to another potentially destructive behavior, Active Trading or trading too frequently. Today’s technology allows investors to trade cheaply from just about anywhere. Overconfident investors now have access to more information and tools that make it easy to speculate on the markets. Unfortunately, this generally results in greater risk, loss of capital, and excess trading fees.
Investors who attempt to time the market often overestimate their knowledge and ability to predict. Overconfidence explains the difference between what they actually know and what they think they know. Analyst, academics and other so-called experts suffer even more from overconfidence than individual investors. Ask an economist to predict whether the stock market will be up or down over the next few years and his forecast is as likely to be wrong as that of a pipefitter. The difference is the economist will offer his opinion confidently.
Early in my business career, the firm I worked for hired a fellow with a reputation for being an expert on increasing business. One of his first suggestions was to avoid a mistake his father had made regarding overconfidence. It seems his dad — who was one of the largest and most highly respected brokers in Philadelphia — decided to deal in commodities for his personal account, against his son’s advice. His success as an investment broker made him overconfident about his ability to trade commodity futures. He leveraged two railroad carloads of egg futures and the prices subsequently fell…and continued to fall further. Refusing to admit he had made a mistake and brimming with overconfidence, he rationalized he could avoid absorbing a loss by taking advantage of his considerable clout with Philadelphia grocery retailers by getting them to take the eggs off his hands for their stores. “You have no idea how many eggs fit into two railroad cars,” the young man laughed. A railroad car contains a minimum of 10,000 pounds; that’s a lot of eggs. Of course, the father had no idea of what two railroad cars full of eggs looked like, nor did he understand how difficult it would be to get someone to take them off his hands. And, of course, eggs have to be refrigerated so they are shipped in refrigerated cars. The railroad in turn charges for every day those eggs remain in the cars. As the dad went about trying to unload this enormous stockpile of eggs, his costs were rising daily, as was the spoilage. Before he could get the supermarkets to take the eggs, a good portion of them spoiled just sitting in the railroad cars. He managed to sell some of the eggs but the majority rotted without ever leaving the cars. He was so hardheaded he thought he could sell all those eggs rather than take a partial loss on the commodity purchase. While he sold a few thousand, his overconfidence caused him to take a financial bath. An egg bath to be precise.
Loss aversion is the tendency for people to place a higher value on something they own than on an identical thing that they do not own. Investors feel the pain of financial loss more intensely than the pleasure felt from financial gain.
Loss aversion also explains why many people will stay to watch a movie they dislike because they’ve paid for the ticket. If we’ve spent resources on something we’re inclined to stay the course so as not to waste what we’ve already spent. In other words, we want to avoid feeling the loss of what’s been spent, so we stick with our plan, hoping for a gain, even when sometimes that just leads to a bigger loss in the long run.
Why are we so averse to loss? It may be evolutionary. Our ancestors learned to survive by taking advantage of opportunities and avoiding threats. Today, we are programmed to hang on to what we already have. The loss of money represents a threat to our survival. Fear and greed drive our emotions. Think about the last time you thought you lost some money or a valuable item. If your wife lost an expensive diamond earring, you both probably felt great angst until an hour or two later when you found it, whereupon you both experienced relief. At that moment, think of how much more that earring meant to your wife than it did before she thought it had been lost. That’s the loss aversion effect.
Investors have been shown to be more likely to sell winning stocks in an effort to “take some profits,” while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.
Regarding loss aversion, researcher Terrance Odean concludes that “individual investors demonstrate a significant preference for selling winners and holding losers, except in December when tax-motivated selling prevails. This investor behavior does not appear to be motivated by a desire to rebalance portfolios or by a reluctance to incur the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. It leads, in fact, to lower returns, particularly for taxable accounts.”
One of our clients got some questionable investment advice about a stock from an accountant friend. She followed his recommendation and bought the stock, which immediately took a nosedive after her purchase. As the stock continued its collapse, she became understandably concerned and asked him if it wouldn’t be a good idea to sell before she lost any more money. His reply was a classic example of loss aversion. He told her not to sell the stock because “there is no loss until you sell the stock.” Well, for tax purposes, that may be true, but in terms of valuation, it’s not. We contacted the accountant on her behalf and tried to explain that while there was no tax loss until she sold the stock, the current value is the current value — that is, what the stock is worth right now. If you bought a house in Detroit for a million dollars years ago, that house is no longer worth a million dollars; it’s lost value and is now worth whatever the market says it’s worth, not what you happened to pay for it. If you have a poor investment that’s lost value, it’s a loss, whether you sell the stock or not. We further suggested that a preferable strategy might be to sell the stock and use the money to find an investment that has a better chance of recouping the loss.
This is the tendency for an investor to follow the actions of the larger group. A quintessential example of herding took place in 2000 when huge numbers of investors who had been mindlessly pouring money into internet related companies saw the dot.com bubble burst. Although many of the stocks they were scooping up at any price were uncertain ventures, the social pressure to conform to what everyone else seemed to be doing created the rationale that such a large group of investors couldn’t be wrong. Of course, they were wrong. Then too, there’s little doubt that commissioned based brokers contributed to the malaise because it’s always easier to sell what is popular.
I had been travelling for two weeks during the early part of October, 1987. The day I returned to work, October 19th, the DJIA lost 22.6% in one day. If you had a million dollars in stock at the opening of trading that day, you only had about $777,400 when the markets closed. I think it was the first time I ever actually pinched myself to make sure I was awake. The financial carnage aside, it was an enlightening moment to see such irrational behavior. People just keep piling on; they couldn’t sell their stocks fast enough. It was an example of the herding bias in capital letters. While it wasn’t necessarily caused by individuals, an awful lot of individuals were swept up in it. Those who panicked and sold out let their emotions get the best of them. In doing so, they abandoned their stocks just as one of the greatest ongoing surges in the history of the stock market was about to take place — and continues to the present day.
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”.
Also known as the status quo bias, regret deals with the emotional reaction people experience after an investment decision.
Regret is a common behavior among investors. They purchase a stock and it immediately goes down. Rather than selling out of the position and holding cash or reinvesting elsewhere, they decide to hold onto the position and continue losing money for fear of feeling bad about taking the loss. Here again, the powerful emotion of fear distorts clear thinking. Meir Statman, Professor of Finance at Santa Clara University and expert on behavioral finance, notes that people tend to feel grief after making an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price.
“People trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats.”
—Meir Statman, “Investor Psychology and Market Inefficiencies”
A series of decision-making experiments shows that individuals disproportionately stick with the status quo. The greatest marketing error in recent decades—the substitution of “new” for “old” Coca Cola stemmed from a failure to recognize status quo bias. In blind taste tests, consumers (including loyal Coke drinkers) were found to prefer the sweeter taste of new Coke over old by a large margin. But the company did not think about informed consumer preferences — that is, their reactions when fully aware of the brands they were tasting. Coke drinkers’ loyalty to the status quo far outweighed the taste distinctions recorded in blind taste tests. In short, so far as marketing was concerned, blind taste tests, despite their objectivity (or, more aptly, because of it), proved to be irrelevant.
Lots of people know there are cheaper gas, electricity, telephone, TV, internet, and insurance packages out there, but they won’t bother switching. Why? Perhaps they can’t be bothered. Perhaps they don’t want to be tied into a contract. Perhaps they’ll have to change their email, which will affect their contacts and internet logins. Perhaps the service won’t be as good. Perhaps something will go wrong in the switchover. For most of us, these shouldn’t be big enough concerns not to make some savings on our monthly bills, but that’s exactly what they are when magnified by status quo bias.
Back in the 80’s, I was using option strategies designed to reduce risk to help a celebrity musician client. As my client became more familiar with how options could reduce risk, he realized that options could also be used to speculate. Of course, I never intended for him to use options to speculate but, as my client grew more familiar with options, he presumed that he had become more knowledgeable about the complex instruments than I was — a case of a little knowledge being a dangerous thing. At the time, there was a lot of leveraged buyout activity and the musician-turned-investment-guru decided to gamble some serious money on leveraged buyout options. What made the decision so imprudent was he was gambling with his pension assets. I advised strongly against it but he persisted. He invested $10,000 in a group of options on a company and as the expiration date approached, they had fallen in value to just $1,000. Then, just one day before the options were to expire, a takeover rumor came out and his options soared in value from $1,000 to $50,000. I had never seen an option make that dramatic an upward movement. I immediately called him and advised he sell some of his options — at least enough to recover his original investment in case the rumor proved to be false. Unfortunately, his regret bias wouldn’t let him do it. He said, “If I sell them, I won’t sleep tonight.” I replied, “If you don’t sell some of them, I’m not going to sleep tonight.” He hung on to the options and the next day, the takeover rumor proved inaccurate and his options went to zero. He had a chance to recuperate his investment and even take a nice profit had he sold the day before, but instead of doing that and being better off, he made himself worse. I don’t know how someone can do that but he did. I subsequently resigned as his advisor.
“If we don’t change direction soon, we’ll end up where we’re going.”
—Professor Irwin Corey
In this behavior, investors compartmentalize their money, which affects how they will spend money differently, depending on the compartment.
Tax refunds are a relevant example of mental accounting as they are often viewed as “found money” to be used for vacations or other discretionary purchases, even though the refund is earned income that was received throughout the year and should be treated the same way.
It is intellectually difficult and emotionally burdensome to figure out how every short-term decision (like buying a new camera or throwing a party) will bear on what will happen to wealth position in the long run. So, as a practical expedient, people separate their money into various mental accounts has a different significance to them.
An example of two behaviors, loss aversion and mental accounting, is a mid-1990s study of New York City taxicab drivers (Camerer et al. 1997). These drivers pay a fixed fee to rent their cabs for twelve hours and then keep all their revenues. They must decide how long to drive each day. The profit-maximizing strategy is to work longer hours on good days — rainy days or days with a big convention in town — and to quit early on bad days. Suppose, however, that cabbies set a target earnings level for each day and treat shortfalls relative to that target as a loss. Then they will end up quitting early on good days and working longer on bad days. The authors of the study found that this is precisely what they do.
Years ago, I had a chat with a neighbor who complained he couldn’t seem to get ahead despite earning a substantial income. I offered to review his financial picture as a favor. I noticed he and his wife took a two-week vacation cruise each year. When I asked where the money for those trips comes from, he told me they put four hundred dollars into a “trip jar” each month so they would be sure to have enough money for their cruise each summer. They had been doing this for several years. Meanwhile, they also had a huge credit card balance that was costing them three hundred dollars a month in interest charges, an account they had been making minimum payments on for the same period of time. They had compartmentalized their debt and vacations into two different mental accounts and couldn’t see how that was a problem.
This bias causes people to choose investments that are familiar or recognizable over those that are not. The behavior can also cause investors to prefer stocks of local companies to those in other states or domestic stocks over their international counterparts. They perceive stocks they have heard about or have some connection to as being less risky.
People who hold stocks of the company they work for may feel more confident because they know the company and its workers, or, they may hesitate to liquidate company stocks for fear their peers will vilify them for doing so.
In years gone by, people changed jobs far less often. It was not unusual for workers in the past century to spend their entire career with just one or two companies. They often held so much company stock that their retirement portfolio was seriously under-diversified but loyalty to their company — which can be a form of familiarity bias — made it difficult for them to liquidate any of their overweighted position.
I’ve known widows who were adamantly opposed to selling any of the stock of the company their deceased husband worked for, despite the unnecessary exposure to risk the holding presented.
Familiarity can also be expressed as an affect, a belief that investment alternatives that are more familiar are better than those that are not. In this case, better usually means that they have higher expected return and lower risk than unfamiliar ones. Researchers Meir Statman, Kenneth Fisher and Deniz Anginer express this affect as, “The feeling of goodness or badness evoked when a stock’s name is mentioned. Even before any analysis is conducted, people have a notion whether they believe a familiar company is good or bad. But what does a good company mean to an investor? A good investment has the characteristics of high return and low risk. Bad investments are viewed as risky with poor returns.
People find a product that they see advertised everywhere better than a product they are not familiar with, even if they do not know anything about the product! The familiarity bias is one of the reasons why branded products are able to command a premium price above white label products. The familiarity bias also results in overestimating and underestimating probabilities. This can affect you in everyday situations as well; say for example if a close relative was recently in a traffic accident, you will most likely overestimate the likelihood of getting into a traffic accident on your daily commute. On the other hand, things that haven’t happened in quite a while and are no longer in the public’s mind are being underestimated. If you don’t know anyone who got diabetes or a heart attack, you will probably underestimate the likelihood that this will happen to you, while you may overestimate your risk of dying in a plane accident.
I had a client who had spent most of his career working for a major bank. In fact, he was the bank’s third largest shareholder by the time he retired. I was selling options on the bank’s stock at the time. The stock was selling for about 62 and we were called on a small number of shares he owned at 55 so naturally, he had to pay capital gains tax on the profit. He called the next day and was angry about having to pay tax. He insisted I never sell another share of his stock. Well the stock eventually plummeted to next to nothing during the banking crisis of 2008 when the government forced a sale to avoid the bank’s failure. The client lost a substantial portion of what he had invested with his employer. Some months later, he called to say he realized he was wrong and that he would never again question my judgment. That was reassuring but he lost a lot of money because he perceived the small amount of taxes he had to pay on a small portion of his holdings as a loss — rather than the unavoidable cost of making a profit on his stock.
When investors base investment decisions on immaterial figures, statistics or prices, it’s behavior known as anchoring.
A simple example would be an investor buying a stock at $50 based on its performance over the past year. When the CEO of the company leaves to take a position with a competitor, the stock falls to $25 and threatens to go lower. But our investor ignores what’s happening and refuses to sell the stock until it goes back to at least $50 because he is anchored to the price he paid for it.
Anchoring causes investors to rely on the first piece of information they receive to make subsequent judgments. It’s one reason why product manufacturers dangle discounts in their advertisements. If you negotiate a price of $48,500 on a BMW that retails for $53,000, you feel good about your purchase because your anchor was $53,000.
The anchoring bias can affect financial advisors as well. In a 2008 study published in Financial Management, researchers documented the results of a survey in which financial professionals used researcher-provided data to predict stock market performance. The savvy, experienced professionals based their predictions on the data that the researchers gave them, instead of using their own judgment. Obviously, even financial professionals are prone to let possibly irrelevant data get the better of them.
Wall Street marketers take full advantage of the anchoring effect by continually creating new products based on sectors that have recently been outperforming the markets. For example, when tech stocks were at their peak, a slew of new funds tied to the tech sector were released. Investors, eager to cash in on the seemingly endless surge in tech stock prices, bought the new funds in record numbers and within a year saw their portfolios plunge in lockstep with the dot.com swoon of 2000.
More about this marketing chicanery in the next chapter.
“Your own mind acts like a compulsive yes-man who echoes whatever you want to believe.”
—Jason Zweig, Wall Street Journal
Finally, I would like to share a story from Benjamin Graham, the father of value investing and one of the most respected investors of the last century:
An oil prospector meets St. Peter at the Pearly Gates. When told his
occupation, St. Peter said, Oh, I’m really sorry. You seem to meet all the
tests to get into heaven but we’ve got a problem. See that pen over there?
That’s where we keep the oil prospectors waiting to get into heaven. And it’s
filled; we haven’t got room for even one more. The oil prospector said would
you mind if I just said four words to those folks? I can’t see any harm in
that, said St. Pete. So the oldtimer cupped his hands and yelled out, Oil
discovered in hell! Immediately, the oil prospectors wrenched the lock off the
door of the pen and out they flew, flapping their wings as hard as they could
for the lower regions. You know, that’s a pretty good trick, St. Peter said.
Move in. The place is yours. You’ve got plenty of room. The old fellow
scratched his head and said, No, if you don’t mind, I think I’ll go along with
the rest of ’em. There may be some truth to that rumor after all!
 Werner De Bondt, Gulnur Muradoglu, Hersh Shefrin, and Sotiris K. Staikouras, “Behavioral Finance: Quo Vadis?”
 Terrance Odean, “Are Investors Reluctant to Realize Their Losses?” Journal of Finance Oct 1998
 “Status Quo Bias in Decision Making,” Farnam Street Newsletter 14 Feb 2012
 Richard H Thaler and Sendhil Mullainathan, “How Behavioral Economics Differs from Traditional Economics,” econlib.com
 John Nofsinger, “High Returns and Low Risk,” Psychology Today 01 July 2008.
 Mark Reijman, “How Familiarity Bias Changes Your Perception,” Business News 27 March 2016.
 Rachel Levy Sarfin, “Anchoring Effects to Influence Decision Making in a Business,” Small Business.