In managing my portfolio of stocks recently, I may or may not admit to falling victim to some of the most ridiculous investor behavior – I can neither confirm, nor deny. I must admit, I was surprised a couple weeks ago, when I woke up one morning, to 47 views of one post in particular of mine: Project prophecy and your phinancial phuture. I guess the tipping point occurred where now many more people are clued in to the dire state of the US economy and how it hinges on a few foreboding economic indicators that predict chaos and disarray. People actually read that post and may have actually gotten something from it. I could insert my smugness here, but really you’re only as good as your next post, so I shall not dwell on my satisfaction for long.
What I will say is finance and investing can sometimes be completely irrational. People hear Apple is splitting its stock, so they freak out and sell it, because it can only mean there is something wrong with the company, or it’s a sleazy predictor of tough financial troubles up ahead. Our markets are based on participants’ behavior. In no other place is it so emotional than when it comes to people’s money – the nest egg for their child’s college tuition, retirement so they can sail the world on a boat, or even a flexible health savings account at work to get laser eye surgery or braces. Investors overreact to good news and bad news. It’s absolutely fascinating.
Investors, just like everyday people, can be incredibly stupid. I love learning about the psychology of investing, and why people make the decisions they do when it comes to money.
The first leg of behavioral finance stands on something called heuristic-driven bias: heuristic refers to allowing a person to learn on their own, usually through trial and error. So, this method of learning relies on the availability of information. There can also be a bias that you develop, your own personal blind spot, because of the source of where you get your information. For example, if you relied solely on the media for information you used to learn about terrorist organizations, you’d have a very biased view, perhaps, that these terrorist organizations are pure evil. So you may lose sight of the similarities you might share with a terrorist – a belief in God, love of country, and wanting to protect your family. If you only relied on the media as your source of information about anything for that matter, you’d have a very skewed, very fearful view of most things.
The second leg of behavioral finance is how decisions and information are framed, or better said, the lens with which you look at available information. Someone raised in times of war, of frugality, and having nothing would approach a financial decision from a much different point of view than someone who was raised in the dot com boom. In one scenario, someone grew up with the fear of losing all their money and most likely would stuff cash in their mattress before investing in the stock market, whereas in the dot com boom, venture capital was flowing freely from the fountain of capital and was available to anyone with an idea and a business plan.
The final leg of behavioral finance is the efficiency of markets. Simply put, because of investor’s overconfident, biased, or flawed rationale when it comes to investing, prices move away from the underlying fundamental value for long periods of time, but eventually revert to the true value. That’s an interesting thought – because it means at any given time, a price does not reflect the true value of something. Because of which information is shared in the distribution channels and publicly available, because of the lens investors are using when they make investing decisions, the market is therefore inefficient, and prices aren’t reflective of value. Alan Greenspan defined the state of the US stock market as that of “irrational exuberance”, and I’d have to agree with him. People are crazy, especially when it comes to money.
OK, my tail is totally wagging now. No shame. Hopefully, you’re not bored to tears yet.
I was a teacher’s assistant in college for a business statistics professor. Yes, I’m a self-proclaimed math geek. There was this concept in statistics of confidence levels and probability curves. Inexperienced investors are more confident in the probability that their investment decisions will beat the market than experienced investors. That is to say, a new investor, acting on some piece of information they think is important will tend to be overconfident in their prediction of what return an investment can produce. Overconfidence is an easy trap to fall into when you are not aware of its existence, and overconfident people are surprised more frequently as things don’t tend to work in their favor.
Let’s chat about something I find incredibly interesting and love talking about at parties (may explain why I’m usually standing by myself by the end of the night): gambler’s fallacy. Wikipedia defines this best, in my opinion, as, “The mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future (presumably as a means of balancing nature).”
For example, in high school, I read Rosencrantz and Guildenstern Are Dead, a play by Tom Stoppard. The opening scene depicts the characters from Shakespeare’s Hamlet, Rosencrantz and Guildenstern, flipping a coin. Despite you and I knowing that the probability of heads will always be 50/50 every single time the coin is flipped, Rosencrantz flips the coin, and it comes up heads every single time. This leads Guildenstern to believe something is wrong with reality because over a long period of time, tails should come up because it too has a 50/50 chance. Gambler’s fallacy is a phenomenon where people inappropriately predict reversal, that future outcomes will trend more to the mean, rather than being approached as independent coin flips with the same odds.
Guildenstern was guilty of gambler’s fallacy – despite the odds being equal, reversal must occur. It’s the law of averages, that over a large sample, we if we flipped a coin 1,000 times, the number of times we should get heads should be close to 500, if the probability is 50/50. However, in that book, they got heads 1,000 times. If someone were to bet that way, they’d find themselves in the hole betting on the tail that never comes… It’s amazing. People will try to predict the process as a whole, the outcome of 1,000 coin tosses, so they may alternate between betting on heads vs. tails every time. Based on the run Rosencrantz had flipping his coin, at one point, one should catch on that betting heads is the better way to go. Look at each coin toss on its own – and if you’ve flipped it 999 times and it’s come up heads, it’s still 50/50 for odds, but if you bet the 1,000th time it would be heads, it would actually have been the most optimal prediction one could make in that scenario. Makes perfect sense, right?
Hersh Shefrin in his book Beyond
Greed and Fear (one of my favorites) postulates that, “When investors are pessimistic, they are overly pessimistic; when they are optimistic, they are overly optimistic.” Investors overreact to all news, good and bad, when it’s released into the market. Based on the lens with which they absorb this newly released information, they’ll often seek and adhere to information that confirms their point of view, and overlook evidence that disproves their point of view. Add to that bias and overconfidence, and you have a recipe for investing disaster.
Don’t believe me?
I think something that has been on the rise with investors and the market alike is that of corporate and social responsibility. There are portfolios specifically designed to be socially responsible – that is, they do not hold alcohol, tobacco, and firearms stocks. The portfolios may invest in companies which have a high community service priority in their mission. They’re after good companies. One thing investors don’t realize though is that very often, good companies have bad stocks. There is a cost to being socially responsible, and not many of these portfolios are money makers. Let’s face it – there is a huge market for all three of those socially irresponsible industries. Whether things are going well, or the world is in chaos, people will not quit smoking, reach for a drink to numb the pain, and defense spending will always be a huge part of the national budget. As an investor, make sure you keep in mind that good companies do not always equal good stocks. So you may be able to sleep at night, because you have a responsible portfolio, but perhaps you shouldn’t be sleeping because your portfolio probably isn’t making as much money as it could.
Here’s a great concept too, that I’m guilty of in my personal life, if not in my investing decisions as well: Get-evenitis. This is the difficulty we experience in coming to terms with our losses. 2013 was a huge year of personal loss for me, and letting go of those is something I still face every day because I’m not completely over the loss of my father.
I give you, as an example, my current feelings toward a stock in my portfolio, Netflix. When I moved back to the US, I immediately opted for a 7.99 subscription to Netflix rather than subscribing to a $100+ cable package with Comcast. Netflix had a great inventory, though not exhaustive and inclusive of all my favorites, so for that price, it was exactly what I needed. It had been an adaptive company, which formed when it saw inefficiencies in Blockbuster, and I’d bought it many years ago after its IPO (knowing about the IPO effect that stocks decrease in value after going IPO). Because it was still around, and had strong fundamentals, a return on assets and equity, positive operating and profit margins, I thought it was a good investment. I bought 30 shares at $428 per share. Seems I bought right at the peak. So later, I bought another 15 shares at $363, and just last week, I bought another 20 shares at $336.
I told myself I was dollar cost averaging, and I thought the company still had solid fundamentals. I checked out recent press releases on Netflix, and the outlook wasn’t looking good, given the recent subscription price increase from 7.99 to 8.99. They charged $1 more per month for their service, and customers reacted. It’s eight-freaking-dollars!
So perhaps, I’m guilty of riding this loser too long, putting more money into a loser, trying to bring my average cost down across multiple lots. Even the best of us make mistakes. However, when it comes to my broader portfolio, I’m sitting on some other stocks with massive accumulated unrealized gains. If I wanted to, I could sell out of those positions to realize those gains, and sell out of Netflix, to offset those gains, minimizing my tax impact on those long term capital gains. So from a tax perspective, I don’t mind holding a losing stock. But the point of investing is not to buy high and sell low – I know that much is true.
As an investor though, when I think about my time horizon, I’m relatively young. I’m in the prime wage-earning years of my life. I’ve had a job with a reputable firm for over 10 years now. While I’d like to have 2 years until I retire (doesn’t everyone want to retire at 35 after becoming a self-made millionaire?), I probably have more like another 30 years until retirement. So my attachment to my nest egg, while strong, is not as strong as someone who will be retiring next year and needs that money. They would have a much stronger inclination towards preservation of capital rather than taking any risk with money they’ll need to start drawing on to live off of next year. So my risk tolerance would be a little higher than the risk that person 1 year from retirement is willing to take. There is a whole emotional timeline for investors that you may or may not realize. These emotions run the gamut from fear (focusing on events where outcomes are unfavorable), hope (focus on favorable outcomes), anticipation waiting for desired outcomes, anxiety when the negative outcome seems most probable, and ultimately, regret for making the decision in the first place. Most would argue that good investors try to minimize future regret with their decisions they make today. Most people lose sight of that, set themselves up for much regret. However, as I’ve learned, and many others before me, I don’t regret the things I’ve done, but those I did not do. We regret inaction, more so than action. Something to consider…
There was a study done on the impact of gender on investing decisions by Barber and Ocean (1998). They studied the trading patterns of men and women, from 1991 to 1997. Performance of investments selected were about the same, but some interesting findings surfaced. Men traded 45% more often than women, and men chose smaller company stocks with high price-to-book ratios and higher betas. As a result, because men chose riskier investments, their return was actually 1.4% less when adjusted for that risk. What was even more interesting is single men traded 67% more, and earned 2.3% less on a risk-adjusted basis. Looks like women tend to be more risk averse than men, but their returns are just that little bit higher because of it.
That buying and selling with tax considerations brings me to a great phenomenon I’d like to share with you, if you haven’t already heard about it. The January effect arises due to the US’ and many other countries’ end of financial and fiscal year being December 31. Many investors will sell off investments in December in order to strategically recognize gains and losses for the tax year before year end. Selling drives a bearish market in the month of December, which is then followed by a bullish market in January, as prices rise again. Many engage in what are known as wash sales, where they will sell to take a gain or loss in December, and buy back the investment within 30 days. This then changes the cost basis of the investment, but allows the investor to continue holding the investment if they speculate long term growth and money to be made. It’s a seasonal anomaly, and it could also be partially explained by year-end bonuses, and people using those bonuses to invest after the new year. It is arguable whether market anomalies like this truly provide arbitrage opportunities, but I find interesting nonetheless that I can predict with some confidence that Netflix tanking this month and allowing me another lower cost tax lot may provide me with a rebound in January, so I’ll hold on to that loser even longer just to see… And on a tangent, does Australia have a similar July effect? I’ve not heard of studies or data, but if the phenomenon holds true that prices are subject to seasonal fluxes, and since Australia’s tax and financial year end June 30, perhaps there is a July effect… I’d be open to the idea of a wealthy benefactor sponsoring my study of this by returning to Australia… Strictly for research, of course…
There’s a lot more interesting stuff out there on behavioral finance, the psychology of investing. I learned about most of the above in the aforementioned book by Hersh Shefrin, Beyond Greed and Fear, but there are so many more resources in this growing field. If any of that made your tail wag like mine, let’s go grab a coffee and chat while our tails wag together. Or give me someone to talk to at that Christmas party about this stuff.
Oh wait… I did.