“The best psychologists are usually the best investors; accountants and figure men usually have the most difficult time...” – Gerald Loeb
In the past, we have discussed how successful investing involves identifying, measuring and managing risk. Moreover, we believe the best investment decisions require a healthy degree of objectivity, much like a doctor diagnosing a patient. In the field of medicine, there is no room for emotions when evaluating and making critical healthcare decisions. For this reason, it is unusual for a doctor to perform a risky or complex medical surgery on a close family member due to the emotional ramifications that might be involved. However, as investors, we are often faced with making critical investment decisions that are impacted by our emotions and psychological biases. Whether we are willing to admit it or not, it is likely that we are less objective in our investment decisions than we may think. In recent years, the study of these biases in investment decisions has led to the field of behavioral finance. While academia has written a great deal on the subject of behavioral finance, this paper will discuss a practitioner’s view on how professional money managers address these biases in daily decision making.
While traditional finance in the context of modern portfolio theory explains the actions of investors based on rational mathematical risk models, the reality is that investors are human, and are far from being rational creatures. As a result, modern portfolio theory has failed to explain inefficiencies and anomalies that occur in the capital markets. This has fueled recent growth in the field of behavioral finance, which is the study of how human psychology influences financial decisions and explains market anomalies. While behavioral finance is still relatively new as an academic field of study, the basic human behaviors that are exhibited are ancient and relate closely to the most primitive predispositions of mankind.
The overall impact that psychological influences have on portfolio returns are often difficult to measure. However, a study published in the October 2011 Journal of Financial Economics found that more than 75% of the variances in the returns of individual stock investing were explained by five of the most common factors addressed in behavioral finance. This study also found that sophisticated investors, who are better informed and more experienced, wisely used mutual funds to achieve good relative returns and to avoid behavioral biases that are common in individual stock investing.
The first bias that we will discuss is the tendency for investors to overestimate their own abilities. Research has found that people have a natural bias to be overconfident in most areas of life. For example, most drivers consider themselves more skillful and cautious than other drivers on the road. In another example, a study conducted in 1977 found that 94% of college teachers viewed themselves as above average and roughly two-thirds of them said they were in the top twenty-five percent of their professional peer group. It is also well documented that people consistently over estimate their own intelligence. When it comes to making investment decisions, the natural bias to overestimate one’s own abilities can result in costly mistakes. These include, overinvesting in the stocks of companies that might be familiar or where a personal connection exists. Overconfidence also has a tendency to cause investors to increase trading frequency, which can erode returns through high transaction costs, taxes, and missed opportunities.
The philosopher Confucius said, “To know that we know what we know, and that we do not know what we do not know, that is true knowledge.” The professional portfolio managers and analysts at Hodges Capital Management confront the issue of overconfidence every day by balancing confidence with a healthy dose of realism. This means making an investment decision with the attitude that we could be wrong. Simply having this awareness helps manage mistakes, which is an important element in successful money management. Furthermore, portfolio managers deal in opinions and predictions. Experience tells us that few things in business or the stock market are easy to predict. As a result, we often find it helpful to study the short story or research that contradicts our own investment thesis on a stock to understand why we might be wrong or what events might derail an investment. Gaining such knowledge can help balance our tendency to be overconfident.
“To know that we know what we know, and that we do not know what we do not know, that is true knowledge.” –Confucius
Another bias that impacts our investment making decisions is frame dependence. This is the tendency to view a scenario differently depending on how it is presented. For example, a retailer offering a shirt for $25 may be perceived as a lesser value than an offer to buy a shirt at the regular price of $50 and get a second shirt free. In either situation, the price of the shirt is the same. However, frame dependence may influence a consumer to perceive more value in the second option. In the context of investing, this cognitive bias can impact an investor’s ability to make rational decisions. Assume an investor buys a stock for $10 per share, and it appreciates to $20 per share. The investor is then presented with the equal possibility that the stock may appreciate another $5 or decline by $10 per share from its current price of $20. Frame dependence may cause an investor to take an inappropriate risk to gain the additional $5 and ignore $10 of potential downside. This occurs because the unrealized profit makes us feel like we are “playing with the house’s money.” This form of frame dependence is known as loss aversion or regret aversion. It is human nature to avoid the regret of leaving another $5 on the table and inappropriately risk losing the entire unrealized gain of $10.
As portfolio managers we often find it helpful to ignore the cost basis that a stock was purchased at when evaluating the overall risk/reward. Don Hodges, founder of the Hodges Mutual Funds and investment veteran of more than 50 years, has often given the advice “the minute you buy a stock, forget what you paid for it.” This helps counter the tendency of frame dependence by recalibrating the portfolio manager’s perception of the upside potential relative to the underlying downside risk. Another helpful tool to combat frame dependence is inverting the facts as they are presented. For example, if data regarding a company’s market share is presented as 5% of the overall market, it may be helpful to invert the data to consider that the company does not control 95% of its addressable market. Inverting the facts as they are presented does not change the situation, but it does allow the investor to process the information with a broader perspective and induce a greater degree of objectivity.
“The minute you buy a stock, forget what you paid for it.” –Don Hodges
The phenomenon of mental accounting occurs when people separate decisions that should be combined. When making financial decisions, assigning different functions to each asset group can sometimes result in irrational behavior. Take for instance, a household budget that has a line item for groceries and another for eating out at restaurants. From a purely financial perspective it would make more sense to have a combined line item for food. As separate line items, mental accounting is likely to cause you to prepare a simple fish dinner at home while you might order lobster and shrimp when eating out at a restaurant. However, it would prove to be more economical to order a simple fish dinner when eating out at a restaurant and buy your lobster and shrimp at the grocery store. While it may not be that practical to combine budgets for eating out and groceries, this behavior is often exhibited in compartmentalizing the way we think about our investment portfolios.
Mental accounting may cause investors to categorize their investment in ways that do not maximize returns relative to an appropriate risk tolerance. It has been found that mental accounting may cause investors to choose the asset allocation for one account without considering the asset allocation and investment objectives of their other accounts. In some cases investors divide their investments between a safe portion of their investment portfolio and a speculative portion of their portfolio in order to separate the negative returns that could occur from speculative investments. Despite segregating the portfolio, the overall value and net worth will be no different.
There are positive aspects of mental accounting, such as it might keep an investor from borrowing from their 401k account to take a vacation. The adverse effects of mental accounting can result in inappropriate portfolio risk and missed opportunities. The less desirable attributes of mental accounting can be countered by looking at the big picture and taking a long-term view of the relevant investment objectives. It is important for portfolio managers to weigh individual investments in the context of the overall risk profile of the entire portfolio and core objectives.
Anchoring & Adjustment
Anchoring & adjustment bias refers to the inability to fully incorporate or adjust to change. Although the reluctance to accept change seems to be a natural human tendency, good investing requires the ability to change direction when the facts or prevailing circumstances change. One example of anchoring we have observed is when analysts are confronted with adjusting their financial forecast in response to changing conditions. In equity research, it is common for a publicly traded company to give updated directional guidance for its annual earnings expectations. Analysts will then derive new estimates from their previous earnings estimates that were based on past performance or anchored to earlier assumptions. This phenomenon is often problematic because the revised earnings estimates tend to stay too close to the status quo, even when presented with new information that may contradict the status quo. The result is inaccurate projections, which can lead to both upside and downside surprises, as well as price inefficiencies within individual stocks.
We have found that a practical solution to address the effects of anchoring and adjustment is to formulate new financial estimates, forecasts, or valuation appraisals from an uncorrupted model that utilizes an entire complex of available information. Compared to making continuous adjustments to previous expectations, this exercise can often neutralize the tendency to rely too heavily on one piece of information or previous assumptions. While it is not always necessary to recalibrate estimates from scratch, having an awareness of the effects of anchoring and adjustment bias can, in and of itself, serve as a tool to improve financial forecasts.
Studies involving brain scans show that peer pressure decreases the activity in the frontal cortex of the brain which handles reflective thinking. Many theories exist as to why our brains are wired to be less reflective when we are part of a group. Some theories suggest that groupthink is a necessity that insures survival by promoting strength in numbers, and point out great advancements that could have only been accomplished through the collective effort of a group. Nevertheless, groupthink can deteriorate the mental efficiencies in making investment decisions by often ignoring alternative options or less obvious opportunities. Groupthink also promotes self-censorship, in which doubts and deviations from the consensus are not expressed. Furthermore, we feel better about being wrong if everyone else in the group is wrong.
Because groupthink is most likely to occur in groups of people with similar backgrounds, it can make an investment team especially vulnerable to faulty decisions. In an environment where funds are managed by a team of portfolio managers, groupthink can often be averted by having security selection conducted on an individual basis. Rather than making buy and sell decisions with the support of a committee of portfolio managers, we have found that individual decisions are best made by a single portfolio manager. Not only does this foster independent critical thinking in the decision process, it promotes an important element of individual accountability. In some cases, it is also helpful to introduce outside options that challenge the view taken internally, which can bring a fresh perspective to investment decisions within a team-managed portfolio.
In summary, we are reminded of a quote from Benjamin Graham, “The investor’s chief problem and even his worst enemy is likely to be himself”. It has been our experience that having a general understanding of behavioral finance can help us become better investors, explain market anomalies, and benefit from pricing inefficiencies that occur in capital markets. It is important to consider that many of the behavioral biases that exist cannot be entirely eliminated. Instead these biases must be simply managed by gaining an awareness that can assist us in becoming more objective in our investing decisions.▪
“The investor’s chief problem, and even his worst enemy, is likely to be himself.” -Benjamin Graham
The above discussion is based on the opinions of Eric Marshall and is subject to change. It is not intended to be a forecast of future events, a guarantee of future results and should not be considered a recommendation to buy or sell any security. Hodges Capital Management does not guarantee the accuracy or completeness of this commentary, nor does Hodges Capital Management assume any liability for any loss that may result from the reliance by any person upon any information or opinions herein. The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.
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