Know Thyself

Shalina Martos, CFP® | October 15, 2016


Are you aware of how you make investment decisions? Are you an analyzer, researching until the sun comes up? Are you someone who buys an item on the spot, no research involved? Knowing how you make decisions, and the emotions that go along with them, is a very important step within the investing process. Let’s explore a couple of typical investor behaviors, and in doing so help you become aware of potential hazards as you weigh decisions regarding your investments. Becoming aware of these can mitigate and redirect your decision-making process, which in turn, will help you become a more self-aware, happier, intelligent investor.

DECISIONS, DECISIONS

Have you ever been in the grocery store ready to check out and logically you pick the shortest line, which then comes to a screeching halt? The longer line right next to you is humming along so you change lines and then that line stops in its tracks! You may have experienced something similar while driving on the freeway. There is often at least one car in a sea of traffic that is changing lanes back and forth, being impatient, and wanting to get an edge on everyone else. Typically within a few minutes, as you proceed ahead at a steady speed, you see the car that was dodging in and out of lanes, pulled over on the side of the road getting a speeding ticket.

With investors, the decision-making process is very similar. In the above examples, people are illustrating the behavior and the same decision-making process as demonstrated by investors who consistently sell low and buy high. When we do this, we are using an arbitrary reference point that we have basically pulled out of thin air!

For example, the moment we are interested in buying a stock or mutual fund and start to research it, the initial price we observe sticks in our mind. We often become fixated on that price as the baseline for our search. We tend to refrain from purchasing that stock or mutual fund until we see a price that is at or below what we initially witnessed. In reality, when you find a price that is lower than the initial price, it seems more reasonable, even if that price is higher than what the stock or mutual fund is really worth. In behavior finance, we call this anchoring.

ANCHORING BIAS

Anchoring can cause investors to ignore undervalued investments that have higher expected future returns, or hold onto overvalued investments which leads to sub-optimal performance.

It is a common psychological function. In a sense, it serves as a mental short cut in the decision-making process, and we all do it to some degree. Understanding its importance, Harvard Law School introduces their students to anchoring behavior in the Program on Negotiation. There they describe peoples’ cognitive bias as the human tendency to rely too heavily on the first piece of information identified (i.e. the “anchor”) when making decisions.

LOSS AVERSION

Loss aversion refers to investors’ tendency of avoiding losses over acquiring equivalent gains. Some studies have suggested that losses are twice as powerful, psychologically, as gains.

There was a study done on loss aversion, conducted by Paul Samuelson (The first American to win the Nobel Prize in Economic Sciences) more than a half century ago. He proposed a bet to one of his MIT colleagues: If he flipped a coin and it landed on heads, he would pay them $200, but if the coin landed on tails, they would owe him $100. His colleague did not take this bet and most people would not, even though logic tells you this is a bet that leans heavily in favor of acceptance.  The thought of losing $100 outweighed the potential positive outcome of gaining $200. He took it one step further and decided to have a multiple data set by flipping the coin twice. He recorded the emotional reactions after each flip of the coin. There are only four possible outcomes, and because the loss has so much more impact, there was only a 1-in-4 chance that the person would have a positive emotional experience even though, in 3 of the 4 scenarios, there was a positive economic outcome. Compare this example to the amount of times per day, month, or year you access one of  your mobile devices to check the balances of your investment accounts. Whether you prefer to use your smartphone, tablet, or wristwatch makes no difference. You are only happy when your account values are higher than when you last checked the balances.

Let’s look at this another way. What if you only checked your account balance once at the beginning of the year, and once at the end? If you could increase your happiness by a factor of 3x, would you modify your behavior? Samuelson ran a similar experiment with the coin flips, and only allowed the people to find out if they had a net positive or negative result after the two flips had been combined. This yielded much more positive emotional results because they did not have to experience the perceived loss along the way.

The life of an investor is not perfect, but there are definitely behavior modifications we can implement to make it more enjoyable.

Steps to take toward a happier investing experience:

1.) Monitor Your Investments Objectively

Keep in mind your risk tolerance, time horizon, and proper diversification as it relates to your overall financial plan and where you are at in the life cycle of investing. Accumulation? Consolidation? Spending? These are all important factors and must be considered as a whole.

2.) Investing Does NOT Stop When You Retire

Be involved and educated on the details of formulating your financial plan and how your investments coordinate with your life goals, healthcare expenses, withdrawal strategies, legacy considerations, and many other factors. A lot of people will be spending 20 to 30 years in retirement. Be sure you have a strategy in place so that your financial plan has longevity. This is not the time to “go to cash.” All you need to do is think about how much a gallon of gas cost when you first started driving, and compare that to the cost of one gallon in today’s dollars. That is called inflation…so be prepared.

3.) Decide On An Investment Philosophy And Stick With It

Making this critical decision and sticking with it will allow you to remain in the eye of the storm while many other investors get carried away by their emotions and the noise of short-term fluctuations. While reading “The Intelligent Investor” written by Benjamin Graham, I came across a comment he made that illustrates why the media wants you to get worked up and take action. I will paraphrase his comment: “Do you know why everyone is clapping and celebrating on the trading floor at the end of every market session regardless of whether or not is was a positive or negative day in the markets? Because they are making money on all transactions whether you are or not!” As an intelligent investor you should be excited when other investors are making mistakes; it is during this time that opportunities present themselves in the market and the disciplined approach wins.

SUMMARY

The anchoring effect and loss aversion concepts are especially challenging for folks who are unaware of such behavioral biases. These biases are decreased among financial professionals, as our expertise serves to minimize the effects and better guide the needs of our clients. When developing investment strategies, educating clients, and implementing financial plans, we understand that being aware of these behavioral hazards is an important part of the equation. Recognizing the anchoring effect and loss aversion biases allows Avier Wealth Advisors to help investors modify their behavior, and adjust their investment strategy to best fit their overall long-term financial plan.

“To reach a port we must sail, sometimes with the wind, and sometimes against it. But we must not lie at anchor.”

-Oliver Wendell Holmes

Posted by Lars Phillips on October 15, 2016