The Enemy of Performance - You

In our practice, we encounter enthusiastic new investors who devour current editions of Money MagazineForbes or the Wall Street Journal in an effort to accelerate their personal learning curve and become more educated about the market. In reality, they may be better off combing through back issues of Psychology Today – because there is considerable evidence that investor behavior is the key determinant to long term results.

fireworks-san-mateo.jpg

The challenge to the investment advisory community is clear: To educate clients and investors – not just about the markets or particular products, but about their own tendencies. In the book Against the Gods by Peter Bernstein, he wrote: Considerable evidence “reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.” We have certainly encountered this in our engagements with thousands of investors over the years (and quite a few “advisors”, too!)

We have found that, as usual, Warren Buffett has it about right. From the June 25, 1999 Business Week interview with Warren Buffett: "Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

The bottom line: Our biggest investing enemy is our brain. The cerebral evolution that formed our brain to be largely focused on keeping us alive in the face of starvation, abandonment and predators causes us to do dumb things when we think we are smart. Here are a few examples of the most common investor tendencies.

Recency bias is the tendency for people to place greater importance on recent data or events over experience. Doing so often leads investors to extrapolate recent trends that are at odds with long-run averages and statistical odds.

  • In a study conducted by Yale University economics professor Robert Shiller, at the peak of the Japanese stock market in 1989 found that 14% of Japanese investors expected a crash. After the crash, 32% said they expected a crash. This illustrates the tendency for investors to become more optimistic when the market goes up and more pessimistic when it goes down.

Herding is the tendency for participants to imitate each other which leads to a crowd effect. The behavior, although rational for individuals, produces group behavior that is, in a well-defined sense, irrational.

  • From the Investment Company Institute, inflows for stock mutual funds were highest during February 2000. (In hindsight, that was clearly the best time in recent history to get out of stocks – at the peak of the subsequent three-year bear market.) The greatest outflows were in July 2002 – just as the market lows were being reached and the recent bull market began. Here is incontrovertible evidence of investors buying high and selling low en masse.

Loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Studies suggest that losses are as much as three times as psychologically powerful as gains.

  • We also describe this as the “fear of regret" which leads investors to avoid selling securities that have declined in value so they won’t have to admit that their original buying decision was a poor one. This “break-even syndrome” is financially costly and an emotionally difficult condition to endure. Have you ever thought or said, “I will sell this stock when I break-even?”

Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are.

  • One study found that 90% of the automobile drivers in Sweden rated themselves as above-average drivers. Moreover, when people say they are 90% sure of something, studies have shown that they are right only 70% of the time.

The reason for overconfidence may also have to do with hindsight bias, a tendency to think that one would have known actual events were coming before they happened, had one been present then or had reason to pay attention. Hindsight bias encourages a view of the world as more predictable than it really is.

  • This tendency is at work in an investor who claims they knew Google would be a great stock when it was purchased in August 2004 (up ~600% over the next three years.) This stock skyrocketed as general market muddled along. He is a genius, of course, and credits that decision to sheer investment acumen. What this investor forgets to mention is he bought Yahoo! at $108 and sold it when it was trading at $4 two years later.