Mentor

Anyone can see an apple in a tree.

But can you see the tree in the apple.

Those who can, ask for nothing but will be remembered for generations.

Keeping Up With Your Neighbor

We tend to engage in social comparisons when we consider our investments and increase the level of risk in our investment portfolio when we perceive that we are falling behind our peers in our investment performance.

Forget (for a moment) about whether you have the same investment objectives, time horizon or risk tolerance as your neighbor. Remember instead that every investor is “right” at least some of the time1. That doesn’t mean your neighbor is any smarter than your brother-in-law Bob2.


1. Remember the line about a broken clock being accurate twice a day.

2. My reference to “Bob” is fictional. There is no “Bob”, never was a “Bob” and never will be a “Bob.” Ain’t that right – Bob?

Projection Bias

People tend to project their current emotional states into the future.


We can remember that we have had other emotional states in the past. Nevertheless we can not imagine that we will feel differently in the future in any fashion other than how we feel at the present time.


This “projection bias” is one of the strongest biases we have. It plays havoc with our ability to plan intelligently for our future1.


Using an independent source to assist in planning helps overcome this bias.


1. This bias explains the extent to which we buy high calorie food while shopping at the grocery store when hungry and explains why we continue to sit in cash until a bull market is well underway before investing.

· OK SO NOW WHAT?

Recently I wrote about “why you still own it.”  Now I think it’s important to discuss “OK so now what.”  What I mean by that is while we are sitting here thinking we are the dumbest bag of hammers on the planet for riding “that sucker all the way down” we have to step back and say “ok we did it and we are going to have to deal with it – so now what do we do?”

In my footnote for the earlier Observation I emphasized that you should understand that market action like this puts you under stress and the longer this goes on and the lower the market goes the more chronic the stress becomes. I stated very plainly that you should not let chronic stress and your desire from relief from that be the cause of the divestiture of your economic assets. In large part your decision should be based on an objective analysis of the assets you hold.  A good way to make the decision to hold or sell an asset is to objectively evaluate whether you would buy the asset if, hypothetically, you had some cash.

Notice I used the word “objectively” and remember that in my view true objectivity is impossible in the investment world.  The best course for us then is to become aware of the emotions affecting us and the biases in investing they cause and then armed with that knowledge try and overcome them (or at least take them into consideration) when making our analysis and decisions. In short, we need to recognize and acknowledge our situation, the emotions we are experiencing and the consequent biases to which we become subject and deal with them as strongly as we can.

OK so how about now?  Well in the current market negative emotions are predominant.  While all negative emotions have the same vector (direction as in “lower” or if you are in California "bummer" dude*) they do not have the same effect on investment decision making.  A short list of negative emotions includes disgust, sadness, fear and anger.

The negative emotion of disgust has been confirmed in behavioral economic studies to cause people to “expel.”  They want to get rid of assets they own.  They do not want to buy new items – their reflexive brain is screaming - get out of the market.

Sadness on the other hand does not cause the desire to “expel.” Studies have confirmed that sadness causes investors to value items that they own less and increase their perceived value of things that they do not own. Sadness reverses the “endowment effect (July 2, 2007 Observation “If it’s mine its mighty fine and if its not it’s not worth a lot”). In other words sadness causes people to (subjectively) want to turn their portfolio over. Although the endowment effect is not good for us, its reversal isn’t either.

The negative emotions of fear and anger have the opposite effect on investors. Fearful investors have been confirmed in studies to be uncertain and pessimistic in their outlook.  This causes them to be risk averse.  Risk aversion increases a subjective desire to sell and flee to “safe assets” even when their account is perfectly balanced and diversified.  As we now know even safe assets can take a drastic decline, so fear is a dangerous emotion because it causes clients to want to de-diversify (is that a word?).

Angry investors oddly enough have been confirmed to have a belief that they have control over their situation.  They are much more certain about the future than uncertain. As a result angry investors are much more optimistic about the future and are not risk averse but risk takers.  When investors become angry (not disgusted) they amplify their risk. If you need convincing take a look at how the markets behaved once the initial shock and fear over September 11, 2009 dissipated and the American public became “angry” – investors caused the markets to engage in strong rallies. Anger may in fact be a beneficial emotion in our current market conditions.

The takeaway here is: identify the negative emotions you or your clients are experiencing, remember what biases then come into effect and what they temp someone to do, deal with that temptation and do your best to recommend or make objective decisions.

That’s enough for this week.  Next week I am going to talk about the fact that people compulsively believe that the way they “feel” (their current emotional state) will be the way they “feel” in the future and how this hurts our ability to plan for our financial futures.

* For those of you not currently sitting on a surf board this word is correctly pronounced "dahoude."

Why You Still Own It

Understandably people have difficulty believing they have ridden a particular stock down (say from slightly above __ to its present price). The answer isn’t that their IQ is below average or that they are otherwise somehow intellectually deficient.

The answer lies in normal human psychological traits which only very experienced professional money managers (say for example Buffett ,Munger or Soros) overcome.

What are those traits? The first is what behavioral economists call “anchoring” and the second is what is called “loss aversion.” The first is not always a necessary ingredient unless the owner tends to hold the stock over time. The longer the time the more significant “anchoring” becomes as a cause of “riding it down.”

Anchoring is a well documented tendency people engage in when asked to analyze something and then make a decision. They establish a reference point – often one that is suggested to them. In the markets the suggested reference point is the price of the security. What price? Almost always it’s the purchase or acquisition price initially. As time goes on (studies say approximately 12 months) the reference point or “anchor” becomes the high for the period in question. For us that morphed into a price somewhere between __ and __ (I will explain why we didn’t lower it as the market price declined or at least to the extent of its decline). What happened to us is that we did not use our actual cost basis but instead used our reference point as our “basis” for making our decision. Anchor is a good choice for the word that describes this trait. It’s heavy and it’s very stubborn and resistant to change once it is set in its place.

There is a second trait that comes into play here and is the real killer. That trait, again well documented, is “loss aversion.” Two prominent economists conducted a study on this phenomenon (other studies followed and confirmed). In short we now know that people have an intense desire to avoid taking a loss from an unrealized (potential) state to a realized (actual) state. Neuroeconomic studies tell us that those portions of the brain which are associated with the emotions of fear and regret become highly active when subjects are forced to decide whether to realize a loss or postpone it. This explains two things. First, why the reference point (anchor) we pick to evaluate whether something is a loss is what economists call “sticky upward” (or when the market price goes up people will move their reference point up but will not move it down when the market price goes down). Second it explains why we ride the stock down – neurons are firing in the portion of your brain (the amygdala) that is telling you to avoid the regret one experiences when the “game” score is final and its a loss (book it Danno). This is subconscious and involuntary (meaning compulsive).

Don’t feel so bad, two geniuses were also significantly affected by this, Newton and Clemens.


Advisors such as Buffett and Soros tell us: never lose track of why you are holding the stock. From time to time reevaluate a particular holding and when you do - evaluate whether you would then make a purchase of the stock (assuming you had some money). Such an evaluation should be a major component in your decision to hold vs. sell 2. Oh and be aware what your anchor is and why you are using it as opposed to a different reference point.


1. Behavioral Economists use the term “disposition effect.”
2. When we have a position that is declining and has been from time we undergo stress. If that decline continues for a sufficiently long time that stress becomes chronic. Chronic stress is debilitating and eventually it overcomes “Loss Aversion.” Chronic stress is the chief cause for investors “throwing in the towel” and abandoning a position that has declined over a significant period of time. This action is taken by mere mortals who are attempting to end the chronic stress they are experiencing. They are seeking emotional relief by disassociating themselves from their “predicament” and they do so by ending the “pain.” It is ka-put, enough already with the stress, who needs it. Emphasizing the “would I buy it now” approach goes along way to relieve this stress and will help eliminate the sale of a good stock at the very time it should not be sold.

Say, if you are so smart why can’t you keep from going broke?

Most often when risk is assumed it is unintentional – by overconfidence in the accuracy and completeness of possessed information and analytical skill. The nature and extent of presented risk is simply not perceived rather than consciously assumed.


People learn lessons in the market – but not for ever. Sooner or later they forget them. They once again become overconfident in their information and analytical skill. They unknowingly assume risk that they did not perceive. The question of a repeat of a past disaster is not if, but when.

Witness:


Remember Long Term Capital Management’s debacle (1998). The lesson learned was found in Merrill Lynch’s contemporaneous annual report where it was observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."

We learned for a while but the use of the Gaussian Copula formula* as a risk modeling device in rating sub-prime mortgage pool securities was not limited and provided an unjustified sense of security (even to, you guessed it, Merrill Lynch) which led to 2008’s even bigger debacle.

That’s why.
 * see  http://gregtevis.blogspot.com/2011_02_01_archive.html

Arbitrary Coherence

In my last Observation I mentioned that people use a point of reference to analyze a situation and make a decision. In effect it is a mental shortcut (aka judgmental heuristic) we use to solve a problem.


Sometimes that reference point resides in our subconscious mind and is in no way relevant to the matter at hand. Psychologists call this tendency “arbitrary coherence” and it’s a companion bias to “anchoring” the bias I discussed last month.

If I asked you to think of the last two digits of your social security number and then evaluate the intrinsic value of a certain stock, did you know that (multiple studies have shown) your responses would vary depending on the value of the ssn digits.

Those of you that have two tailend ssn digits closer to 99 would tend to value the stock higher than those of you that had digits closer to 00.

Like many of the mental biases we have being aware of this tendency allows you to adjust for it - but doesn’t make it go away.

Anchoring

People use a reference point to decide something. Psychologists call it an “anchor.” Often the use of a reference point is not a conscious decision and not a rational choice.


In the world of personal investing price is often the reference point when deciding whether to hold or sell a position. If the position has been held less than a year then we tend to use the purchase price in deciding whether to hold or sell. More than year then the reference point is the year to date high price.


My advice is to make sure the anchor is a known and rational choice.

To Invest or Not to Invest. That is not the Question

To invest for the future you have to invest. When, how much and in what are all subject to debate but not whether to do it at all. That goes for far more than financial matters.