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Your Brain Is Killing Your Returns

Every year, Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. (click to enlarge) George Dvorsky once wrote that: The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless – plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions .” Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money . As history all too clearly shows, investors always do the “opposite ” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process . Here are 5 of the most insidious biases that will keep you from achieving your long-term investment goals. 1) Confirmation Bias As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position . This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. (click to enlarge) The issue of “confirmation bias” also creates a problem for the media. Since the media requires “paid advertisers” to create revenue, viewer or readership is paramount to obtaining those clients. As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to “confirm” their current beliefs. Individuals want “affirmation” that their current thought process is correct. As human beings, we hate being told that we are wrong, so we tend to seek out sources that tell us we are “right.” 2) Gambler’s Fallacy The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally-driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same . The bias is clearly addressed at the bottom of every piece of financial literature. Past performance is no guarantee of future results .” However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future. This is one of the key issues that affect investor’s long-term returns. Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next . This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.” (click to enlarge) I traced out the returns of the Russell 2000 for illustrative purposes but importantly you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns. 3) Probability Neglect When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. It is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.” As investors, we tend to neglect the “probabilities” of any given action which is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is that most of the gains are likely already built into the current move and that a corrective action will occur first. Robert Rubin, former Secretary of the Treasury, once stated; As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made. Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision .” Probability neglect is another major component to why investors consistently “buy high and sell low.” 4) Herd Bias Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted I need to do it too. In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets the “herding” behavior is what drives market excesses during advances and declines. As Howard Marks once stated: Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’ Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.” Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede. 5) Anchoring Effect This is also known as a “relativity trap” which is the tendency for us to compare our current situation within our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me what exactly that you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not. The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we assume that the next home purchase will have a similar result. We are mentally “anchored” to that event and base our future decisions around a very limited data. When it comes to investing, we do very much the same thing. If we buy a stock and it goes up, we remember that event. Therefore, we become anchored to that stock as opposed to one that lost value. Individuals tend to “shun” stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right? This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then that they panic “sell” and are now “anchored” to a negative experience and never buy shares of ABC again. In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions. Take a step back from the media and Wall Street commentary for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets? As individuals, we are investing our hard earned “savings” into the Wall Street casino. Our job is to “bet” when the “odds” of winning are in our favor. With interest rates at abnormally low levels and now beginning to rise, economic data continuing the “muddle” along and the Federal Reserve extracting their support; exactly how “strong” is that hand you are betting on?

To Diversify Or Not To Diversify?

Summary Investment risk – or probability of losing money – can’t be measured precisely (outside of casinos and some other narrowly defined domains). It’s impossible to predict how a stock will perform in the future; sometimes the safest-looking stocks turn out to be the riskiest. Which is why it’s never wise to put all of your eggs in one basket… if the basket is dropped, all is lost. Diversification is a more robust approach, because it allows you to make (small) mistakes without destroying your portfolio. When one asks me how I can best describe my experiences of nearly forty years at sea, I merely say, uneventful. I have never been in any accident of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked, nor was I ever in any predicament that threatened to end in disaster of any sort. The above quote comes from a 1907 interview with Captain E. J. Smith. Five years later, he was captain of the Titanic when it hit an iceberg and sank. More than 1,500 people, including him, went down with the ship. The Titanic disaster illustrates perfectly the dangers of inferring the future from the past. Just because something hasn’t happened before doesn’t mean it’s impossible. It sounds almost too obvious, but it’s a common mistake made in the world of finance. Consider the story of the infamous hedge fund Long-Term Capital Management (LTCM). Like the Titanic, LTCM was supposed to be “unsinkable.” It was run by a so-called “dream team” of Wall Street professionals, academics, and two Nobel Prize winners, all of whom – like Captain Smith – had impeccable track records. But then in 1998, after only four years in operation, the excessively leveraged LTCM collapsed like a house of cards. This time, the iceberg was Russia defaulting on its debt – something LTCM’s risk models, which relied on limited historical data and phony bell curve-style statistics, never saw coming. Unfortunately, LTCM wouldn’t be the last to make this mistake. This same over-reliance on flawed risk models later led to the 2008 financial crisis, resulting in the demise of many major financial institutions, most notably Lehman Brothers. These disasters have taught us that financial markets aren’t a casino with simple bets; real-world risks are more complex and can’t be measured precisely. Historical data never fully reflects all of the possible events that could take place (recall Captain Smith who “never sunk before”). Moreover, statistical risk-measuring tools are largely useless, particularly when dealing with rare events (i.e., black swans). The best way around this risk measurement problem is to simply ignore it, and focus on the consequences instead. For example, I don’t know the odds of an earthquake in Tokyo, but I can easily imagine how a heavily populated city like that might be affected by one. Similarly, it’s easy to tell that a highly leveraged bank is doomed should a crisis occur, but predicting when and how severe that crisis will be is a fool’s game. In short, it’s much easier to understand if something is harmed by shocks – hence fragile – than try to forecast harmful events. This whole notion of fragility has important implications in portfolio management, particularly when it comes to deciding how many stocks to hold. There are two schools of thought on this. One suggests that we should spread our eggs across many baskets. The other says that it’s better to put all your eggs in just one basket and then watch it carefully. So, who’s right? The school advocating broad diversification is, because it makes your portfolio less fragile to bad bets. The critics, however, claim that diversification is a recipe for mediocre returns. You don’t get on the Forbes Richest List by diversifying, they argue, but by concentrating your bets on few stocks. It’s true. You probably won’t become a billionaire by holding a well-diversified portfolio. But the reverse is also true – those on the “Fools Gone Broke List” also concentrated their bets, and paid a big price for it. Ignoring these losers is financial suicide. The point is, concentrated investing is like playing the lottery – you could get lucky and win big, but it’s far more likely that you’ll lose. Diversification, on the other hand, is insurance against the extreme unpredictability of any one stock. It makes your overall portfolio more robust, preventing one or two losers from ravaging your wealth. So, how many stocks do you need to be sufficiently diversified? A simple way to approach this question is to ask yourself: What’s the most I can afford to lose if one of my stocks goes bankrupt? For the typical investor, it’s about 5% – the equivalent of owning 20 stocks in equal proportions. Now, let’s view this from another angle. Owning just 10 stocks eliminates 51% of portfolio volatility (i.e., diversifiable risk). Adding 10 more stocks eliminates an additional 5% of the volatility. Increasing the number of stocks to 30 eliminates only an additional 2% of the volatility. And that’s where the good news stops, as further increases in the number of holdings don’t produce much additional volatility reduction. In short, it’s possible to derive most of the benefits of diversification with a portfolio consisting of 20 to 30 stocks (assuming they’re diversified across industries, geographies, and market capitalizations). Contrary to what the critics often claim, adequate diversification doesn’t require 100-plus stocks in a portfolio. The Benefits of Diversification Note: Portfolios are equally weighted. Volatility is calculated as the annualized standard deviation of historical stock price returns. Source: A North Investments, Elton and Gruber Study The central idea of this article is that investment risk (or the probability of losing money) can’t be measured precisely. It’s impossible to predict how a stock will perform in the future. Even the safest-looking stocks can surprise you. Remember Enron? Before it became a symbol of corporate fraud and corruption, Enron was widely regarded as one of the most innovative, fastest-growing, and best managed companies in the world. It was the “darling of Wall Street,” a stock you could “buy and hold for a lifetime.” It was rated a “buy” or “strong buy” by most analysts. Thousands of investors put their life savings into the stock, thinking it was a “sure thing.” Most would never see their money again. Enron is the perfect example of why you should never put all of your eggs in one basket. If the basket is dropped, all is lost. Diversification, on the other hand, allows you to make (small) mistakes without destroying your portfolio. It’s a more robust investment approach. Some call it “protection against ignorance,” and they’re absolutely right. We’re all ignorant; some of us just don’t realize it yet.

Metaphors And The Message: Searching For Deeper Understanding Of Investment Information

Metaphors have a powerful impact on shaping our thoughts and on what information we consider important. The machine metaphor is often used in describing economies and markets and as such, often depicts them in an unfairly positive light. For a number of different reasons, the ecology metaphor is more useful and appropriate for long term investors. By paying attention to the metaphors used, curious investors can gain a great deal of insight about the related content. One of the more interesting and unsettling experiences I’ve had was scuba diving at night. This combined an activity (scuba diving) for which I had only a beginner’s skill with an environment (pure darkness) that was challenging. The most unnerving aspect of the experience was only being able to see what was in the narrow cone of light from my flashlight; I had no peripheral vision in the darkness. While there were plenty of interesting things to see ahead of me, I also wanted to avoid damaging the coral inadvertently and I definitely wanted to avoid anything potentially dangerous. This example serves as a good illustration of how metaphors fundamentally shape our view of the world. “Metaphors govern the way we think about issues,” according to Gary Klein in Sources of Power. Klein elaborates, “It [metaphor] structures our thinking. It conditions our sympathies and emotional reactions … It governs the evidence we consider salient and the outcomes we elect to pursue.” Much like a flashlight in dark water avails us only a very limited view, so too do our mental models and associated metaphors only shine light on relatively narrow expanses of reality. Given the power of metaphor to “structure our thinking” and “govern the evidence we consider salient,” it behooves us to scrutinize the metaphors we embrace in order to think about the right things and evaluate the right evidence. Do the metaphors cast wide beams of light or narrow ones? When do they cast light on important matters and when do the leave important considerations in the dark? Because it is so commonly applied to the economy and markets, the metaphor of machine is particularly interesting to investigate. Unfortunately, the machine metaphor breaks down (sorry!) in a number of situations and this has very significant implications for investing and risk management. We find evidence of the machine metaphor throughout business and investment communications. A company may be “grinding through” some challenges or an economy may be “running smoothly” or “running like clockwork.” In addition, the concept of momentum (which also stems from the physical sciences) is frequently used to characterize economies and markets. We find evidence in statements like, “the economy is humming along” or “the economy has strong momentum.” When we examine such statements carefully, however, we can gain insights into the breadth and direction of the “light beam” of the metaphor. For example, when I think of something as having momentum, I think of a semi tractor trailer flying down a mountain highway. The relevant principles behind momentum in this case come from the physical sciences. The constant and universal force of gravity exerts its pull on the truck. Since momentum is conserved (i.e., it persists until affected by an outside force), an outside force is required to change it. From this perspective, there is little about the notion of momentum that accurately describes what happens in an economy. For one, economic growth is not a “constant and universal force” like gravity is. It depends on a lot of things all of which change over time. Secondly, economic “momentum” is not conserved. An economy can, and frequently does, speed up or slow down largely due to factors within the economic system and not due exclusively to external factors. As a result, the simple use of the word “momentum” invokes a metaphor (physical sciences, loosely machines) that shapes how we think about the economy and in most cases in an unduly positive light. While the machine metaphor is often used in regards to economic output, so too is it applied to economic risks. For example, the Fed has talked of raising interest rates in order to “keep the economy from overheating,” just as one would apply brakes in a car to slow it down. In addition, The Fed has communicated goals of increasing rates when unemployment reaches a certain level, which invokes the image of a thermostat turning off the heat when a room hits the desired temperature. In both cases, the economy has proven far more dynamic and unpredictable than the Fed’s machine metaphor would suggest. Even with these inadequacies, however, the machine metaphor often performs well enough in periods of stability. The real problems arise over longer periods of time when stability is not a good baseline assumption. What is normal is that over time, significant disruptions occur and these events often violate the assumptions under which machines normally operate. In the physical world, extreme events such as earthquakes and tsunamis are well known disruptive events. In the economy, events such as geopolitical crises and rapid credit tightening are similarly disruptive. One of the most important qualities to understand about such disruptive events is that they aren’t predictable. As John Lewis Gaddis notes in The Landscape of History , “Poincare had been right; some things are predictable and some are not.” These types of events are not predictable namely because of complexity. While we can understand some of the preconditions for such events, there are just too many variables all interacting with one another. As Nassim Taleb noted in his book, Antifragile , “With complex systems, interdependencies are severe – you need to think in terms of ecology.” This insight goes a long way in explaining the biggest weakness of the machine metaphor: When disruptive events happen, the assumptions of smooth machine operation are often violated. An electric motor can run well in a dry environment, with normal temperatures, safe from disturbances, and with a reliable power source. However, if any one of these requirements change, the motor is likely to not run nearly as well or to not run at all. Taleb’s insight also goes a long way towards identifying a more robust metaphor, that of ecology. Gaddis corroborates this finding when observing that, “Historians have a web-like sense of reality, in that we see everything as connected in some way to everything else.” In this way, historians are especially well placed to piece together multiple variables often connected in surprising ways. In suggesting that, “History is arguably the best method of enlarging experience,” Gaddis is also effectively endorsing the ecology metaphor as the biggest flashlight with the widest beam. How can investors make use of this? First, investors can use metaphors to “enlarge their experience” and thus prepare their minds in the process. Think of the nuclear incident at Fukushima. The emergency power generators kept the cooling pumps working beautifully – right up until they were flooded by the tsunami. Normal operating conditions were violated. In a similar vein, investors can invoke the ecology metaphor to inquire as to how the environment might change and as to what wild things can happen or have happened that can cause serious problems? Among such possibilities, the massively interconnected and highly leveraged international finance system could certainly freeze up again. Inflation is not a problem now, but certainly could be an issue before the end of a long investment horizon. Fiscal deficits and high debt burdens also suggest a future of higher taxes. None of this is to say these things will absolutely happen. It is to say, however, that they are distinctly possible and if they do happen, normal operating conditions for conventional investment strategies are likely to be violated with significantly negative consequences for investors. This is essentially the same thing as developing situational awareness and is analogous to developing a tornado watch methodology. Second, investors can make sure to align their investment horizon with the most compatible metaphor(s). If one has a very long investment horizon, then one should manage his/her portfolio to withstand all of the crazy things that can happen over a very long period of time. As a guide, Taleb observes that “Nature likes to overinsure itself.” He even goes so far as to say that, “The secret of life is antifragility.” As a result, long term investors should focus first on avoiding devastating losses because the problem with fragility is that it “has a ratchetlike property – irreversability of damage.” By this logic, avoiding large exposures to assets that can plummet in value in certain situations and using insurance when it’s cheap make sense. Importantly, long term investors should remain firmly focused on the long term and the big picture. In other words, don’t manage relative performance day to day, quarter to quarter, or even over three year periods. They just aren’t long enough to provide useful perspective. As a reminder, the Fed last raised rates over eight and a half years ago, the ten year Treasury bonds currently yield under two percent (a threshold it never breached during the entirety of the Great Depression) and the Fed has increased its balance sheet over $3.5 trillion (over $30,000 per US household) since the beginning of 2008. Individually and collectively these conditions are not even remotely normal in the broader context of financial history and therefore provide an exceptionally poor basis of expectations for long term investors. In short, things are likely to change and quite possibly change dramatically over a long investment horizon. An avoidable mistake is to assume you can just plod along and indefinitely defer preparations for a very different future. Third, it’s useful to consider the fact that since metaphor is such a powerful force in shaping our view of the world, people often use it as a tool to mold our perceptions. Government officials, media talking heads, business leaders, and even investment managers may have incentives to tell a story or to persuade more than to inform. The pernicious consequence for investors as that people so motivated don’t even need to risk giving bad information; they can simply employ inappropriate metaphors. In fact, this may very well be the reason why we hear momentum used so frequently in describing economies and markets – because the metaphor itself creates an unduly positive perception. The main antidote to this reality is to scrutinize metaphors as being part of the message. On this note, twice in two days this week I’ve heard the suggestion of the S&P 500 hitting 3,000. I find this especially interesting because it seems to employ a gambling metaphor. Long term investors should be interested in valuations, fundamentals, risks, and tradeoffs. Specific targets for the S&P 500 aren’t really relevant to their process. More specifically, there is absolutely no reason why anyone should use record highs as the standard for long term investing. Alternatively, hitting 3,000 does sound like hitting the lottery and therefore suggests a gambling metaphor. Insofar as this is the case, long term investors can recognize such messages as being directed to a different group of people and as one devoid of salient information for them. By the same token, some discussions obviously employ the ecology metaphor which is more appropriate for long term investors. Gene Frieda, of Moore Europe Capital Management, provided a good example in a recent piece in the Financial Times . In writing that, “The roots of the recent return of financial market volatility are not in fundamental factors, but rather reflect the Tower of Pisa-like financial architecture that has grown in the wake of the global financial crisis,” Frieda is explicitly describing the fragile (Tower of Pisa-like) nature of the financial system and its relevance as an important environmental factor affecting volatility. In observing that, “Renewed volatility is forcing market participants to recognize just how much the structure of financial markets has changed since 2008,” he is recognizing how the nature of financial markets has evolved due to the interactions of participants with each other and with a different environment. Finally, Frieda notes that, “The cut in market liquidity creates an illusion of underlying strength to market rallies when some of the strength is a function of worsening market depth. To the extent investors and policy makers judge the strength of fundamentals by the behavior of asset markets, this has created a false sense of security – about the robustness of the US recovery and eurozone resilience to new shocks.” In doing so, he is clearly accounting for the possibility of disruption. In conclusion, it is difficult enough to get one’s arms around the investment environment when overwhelmed with massive amounts of information and distracted by countless cross-currents. As such, metaphor can be a useful and practical tool in distilling overwhelming detail into digestible nuggets of insight. But metaphors also have important limitations — which curious investors can use to their advantage. For one, investors can calibrate communications by the metaphors used to achieve a deeper understanding of the message. Further, investors can, and should, be selective in focusing on metaphors that align best with their investment philosophy and goals and importantly, to avoid those that are not well aligned. (click to enlarge) Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.