Congratulations to University of Chicago’s Richard Thaler for his recent Nobel Prize in economics! This isn’t the first time we’ve mentioned Professor Thaler. I referenced his work last year. And here, Rick Hill shared a conversation between Professor Thaler and fellow Nobel Laureate and University of Chicago colleague Eugene Fama. Thaler also is well known for his groundbreaking book, Nudge: Improving Decisions About Health, Wealth, and Happiness.”
Why do we keep mentioning the guy, and why does the Nobel committee agree that his work is worth recognizing? I can’t speak for the Nobel committee, but I can say that understanding Thaler’s many contributions to behavioral economics is essential to anyone who wants to Take the Long View® with their wealth. Just as financial economics focuses on how to best manage the market’s idiosyncrasies, behavioral economics focuses on how to curb our own behavioral biases, which often pose the greatest threat to our financial well-being.
When it comes to defending against your behavioral biases, forewarned is forearmed, so here’s a summary of some of our most damaging, if all-too-human traits.
The Bias: Anchoring
- Symptoms: Anchors aweigh! It’s easy for us to fixate and base ongoing decisions on an initial piece of information (the “anchor”), even if it’s no longer relevant to the decision at hand.
- Damage Done: “I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.”
The Bias: Blind Spot
- Symptoms: The mirror might lie after all. We can assess others’ behavioral biases, but we often remain blind to our own.
- Damage Done: “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Daniel Kahneman)
The Bias: Confirmation
- Symptoms: This “I thought so” bias causes you to seek news that supports your beliefs and ignore conflicting evidence.
- Damage Done: After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change.
The Bias: Familiarity
- Symptoms: Familiarity breeds complacency. We forget that “familiar” doesn’t always mean “safer” or “better.”
- Damage Done: By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) you decrease global diversification and increase your exposure to unnecessary market risks.
The Bias: Fear
- Symptoms: Financial fear is that “Get me out, NOW” panic we feel whenever the markets turn brutal.
- Damage Done: “We’d never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” (Carl Richards)
The Bias: Framing
- Symptoms: Six of one or half a dozen of another? Different ways of considering the same information can lead to illogically different conclusions.
- Damage Done: Narrow framing can trick you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your total portfolio.
The Bias: Greed
- Symptoms: Excitement is an investor’s enemy (to paraphrase Warren Buffett.)
- Damage Done: You can get burned in high-flying markets if you forget what really counts: managing risks, controlling costs, and sticking to plan.
The Bias: Herd Mentality
- Symptoms: “If everyone jumped off a bridge …” Your mother was right. Even if “everyone is doing it,” that doesn’t mean you should.
- Damage Done: Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with.
The Bias: Hindsight
- Symptoms: “I knew it all along” (even if you didn’t). When your hindsight isn’t 20/20, your brain may subtly shift it until it is.
- Damage Done: If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.
The Bias: Loss Aversion
- Symptoms: No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.
- Damage Done: Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.
The Bias: Mental Accounting
- Symptoms: Not all money is created equal. Mental accounting assigns different values to different dollars – such as inherited assets vs. lottery wins.
- Damage Done: Reluctant to sell an inherited holding? Want to blow a windfall as “fun money”? Mental accounting can play against you if you let it overrule your best financial interests.
The Bias: Outcome
- Symptoms: Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills.
- Damage Done: If you misattribute good or bad investment outcomes to a foresight you couldn’t possibly have had, it imperils your ability to remain an objective investor for the long haul.
The Bias: Overconfidence
- Symptoms: A “Lake Wobegon effect,” overconfidence creates a statistical impossibility: Everyone thinks they’re above average.
- Damage Done: Overconfidence puffs up your belief that you’ve got the rare luck or skill required to consistently “beat” the market, instead of patiently participating in its long-term returns.
The Bias: Pattern Recognition
- Symptoms: Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.
- Damage Done: By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.
The Bias: Recency
- Symptoms: Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.
- Damage Done: If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns.
The Bias: Sunk Cost Fallacy
- Symptoms: Throwing good money after bad. It’s harder to lose something if you’ve already invested time, energy or money into it.
- Damage Done: Sunk cost fallacy can stop you from selling a holding at a loss, even when it is otherwise the right thing to do for your total portfolio.
The Bias: Tracking Error Regret
- Symptoms: Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them.
- Damage Done: It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers.
Even once you’re familiar with the behavioral biases that stand between you and clear-heading thinking, you’ll probably still be routinely tempted to react to the fear, greed, doubt, recklessness and similar hot emotions they generate. This is one reason an objective advisor can be such a critical ally, helping you move past your reactionary thinking into more deliberate decision-making for your long-term goals.
If you could use some help managing the behavioral biases that are likely lurking in your blind spot, give us a call. In combating that which you cannot see, two views are better than one.
Quick, what’s the difference between a market-cap-, equal- and price-weighted stock market index? Fortunately, if you’re not sure, our friends at Dimensional Fund Advisors just published an excellent piece on this very subject. We invite you to read it here, but here’s our overview.
If you think of a market as a big box, there are several ways each stock that belongs in that box might “weigh in” to help fill it:
Market-Cap Weighted – If we fill a market box according to each stock’s market capitalization (share price multiplied by shares outstanding), the stocks with the biggest market caps (e.g., Apple stock – AAPL) weigh the heaviest, or occupy the most space, as Dimensional depicted here:
Equal Weighted – If, each security is instead given equal space in the box regardless of its market-cap, an equal-weighted market will look more like this:
Price Weighted – As described in this recent New York Times piece (which may require a subscription to access), the Dow Jones Industrial Average is the only popular index that uses price weighting, where the highest-priced stocks take up the most space. (Almost everyone agrees, price-weighting is pretty arbitrary, especially since the Dow tracks only 30 U.S. stocks to begin with. But as the world’s first and oldest index, the venerable Dow essentially gets to do as it pleases.)
So what does all this mean to you as an investor? As Dimensional’s illustrations depict:
- If you were to invest all of your money in a single market-cap-weighted index fund, you’d end up holding a much heavier allocation to large-cap stocks, be they value or growth.
- If you were to invest everything in an equal-weighted index fund, you’d end up holding more small-cap stocks than would otherwise be warranted by their cap-weighted presence in the total market.
Now, here’s where things get a little complicated, so bear with me. At first glance, you might conclude you’d be best off investing in an equal-weighted index fund, to capture more of the higher expected small-cap value premium. After all, that’s where the biggest small-cap value “blob” appears, right?
Not so fast. First, we’ve got to remember that an index is just a theoretical collection of stocks. When an investor or fund manager seeks to replicate an index by placing actual trades on those stocks, they run into real-life trading constraints. This is especially so when tracking an equal-weighted index, where far more frequent trading is likely to be the norm.
Put plainly, keeping up with the evolving components in an equal-weighted index can get very expensive, very fast.
“[U]sing a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.”
Which brings us back to evidence-based investing as we know it. Want to know more? Here’s a past post on index- vs. evidence-based investing. Or just give me a call to continue the conversation.
Exhibit 1: For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.
Exhibit 2: For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.
Have you ever wondered what Batman & Robin would be like if Batman were the understudy to a more famously popular Robin? It would probably be a lot like the real-life dynamic duo of Warren Buffett and Charlie Munger.
As Chairman of Berkshire Hathaway, Buffett is the more familiar figure. He’s been featured in his own HBO special. He’s got his own “Oracle of Omaha” nickname. He’s chairman of Berkshire Hathaway. Munger is vice-chair of the same, and often described as Buffett’s sidekick, even though he’s the elder of the two, is also an astute Omaha native, and was running his own successful holding company while Buffett was still learning the ropes. As Buffett himself describes of Munger:
“[W]e’ve never had an argument. When we differ, Charlie usually ends the conversation by saying: ‘Warren, think it over and you’ll agree with me because you’re smart and I’m right.’”
So who’s the real “Batman”? Let’s turn the spotlight on Munger for a change, showcasing some of his “elementary worldly wisdom” – a phrase Munger uses to describe how he builds models for converting isolated insights into applicable common sense.
Translating the complex into useful ideas. This is something we like to do here at Hill Investment Group as well. To get a sense of how a master like Munger does it, here’s a 15-minute YouTube video with excerpts from a talk on human psychology, which Munger delivered at Harvard in 1995.
Munger uses approachable analogies ranging from Pavlov’s dogs and New Coke, to target shooting and gallbladder surgery to entertain and inform us with “how humans trick themselves into making terrible errors of judgment.”
In our best judgment, Munger is well worth watching and reading, with plenty more elementary worldly wisdom to share. If that’s of interest, let us know and we’ll be glad to tell you more.