MARKET OUTLOOK FOR SIA CHARTS
Behavioral Finance and the Importance of sticking to the Long-Term Plan
• Behaviors effect on market returns
• Brief introduction to some behavioral biases
• If you’re more interested in the topic we may be able to set up a lunch and learn
We have all made poor judgement calls in the past that have cost us money whether it’s hanging onto a loser stock for too long, selling out of the market and watching it rally or deviating from our long term goals because of short term noise or fear. The volatile decline early in the year and the subsequent rebound has definitely tested all market participants’ decision making processes.
Most world famous investors who books I’ve read believe that controlling emotions key to success in the market. However, we are all human beings and in being so are subject to inherent cognitive and behavioral biases that are present in us all. What’s worse is that the markets are extremely efficient in parting investors who demonstrate these hard wired biases from their hard earned investment money.
This is confirmed by DALBAR who is a leader in quantitative analysis of investor behavior. The below graph shows average do it yourself investor return verse major indices. You can see that the average equity investor over the 20 years studied has returned 3.8% verse 9.1% for the S&P500 index. The difference is chalked up to how these individual investors negatively behave in the market.
In real money terms the return on a base of $100,000 over 20 years at 3.8% per annum would be worth $210,837 verse a return of 9.1% per annum being worth $570,815. A huge difference!
Understanding inherent biases we use in decision making helps close the gap. There are many biases but I’ll focus on 3 well known ones:
1) Overconfidence occurs when investors mistake familiarity for knowledge and believe this familiarity allows them to make a better decision then their peer group. Common beliefs are that intellect trumps due diligence and more knowledge equals better decisions. Employees of publicly traded companies tend to overweight their holdings because they have confidence in their company based on antidotal knowledge. However, very few know key specific detail such as the companies free cash flows, dividend payout ratio, return on invested capital ratio, financial leverage, current value multiples verse the last 5 years and current valuation in its peer group. All this information should be looked at but investors are blinded by familiarity of the company they work for.
2) Anchoring and Adjustment occurs when people start with an implicitly suggested reference point (the “anchor”) and make adjustments to it to reach their estimate. A major example of this is when an investor focuses and makes decisions based on their purchase price of an investment instead of the current price. How many times have you taken large losses and an investment you knew was a loser because you tried to sell at your purchase price instead of taking a small loss? The market doesn’t know or care what your purchase price is and certainly doesn’t move around it, yet it so fundamental in most people’s decision making process.
3) Probabilistic Thinking occurs when an investor uses a small sample size to reflect the results of a large sample of data. The best example of this the player in roulette who watches black come up on the wheel 5 times in a row then goes all in on red because they are sure it’s going to win believing the odds are 2^6 (64:1) of six blacks in a row. Not knowing 5 events have already happened and the current event is still 50/50 excluding the houses take.
Investors engage in this risk taking trying to play the short term range in stocks clipping a small return each time. This works until you hit that one event were you go in and instead of rising like usual it crashes and you lose all earned to date and more.
This is 3 of many identified biases that cause individual investors to underperform. The best way to ensure you meet your goals is to stick with a disciplined long term diversified portfolio that has been set up when emotions and cognitive biases were not part of the equation. As advisors one of the major and most underappreciated value ads is keeping average individual investor emotions out of the investment process and keeping them on a diversified long term plan.
This topic is way too far reaching to cover in a newsletter but if you would like to know more we have talked to one of the main proponents of behavioral finance in Calgary who is willing to cover the topic in more depth for our clients. If you’re interested in attending a lunch and learn please reach out to Jan Morrison at email@example.com. If there is enough interest we will set a date in June.
This newsletter was prepared solely by Bruce Morrison who is a registered representative of HollisWealth™ (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). The view and opinions, including any recommendations, expressed in newsletter are those of Bruce Morrison only and not those of HollisWealth. TM Trademark of The Bank of Nova Scotia, used under license. Morrison & Partners Wealth Strategies is a personal trade name of Bruce Morrison.