Emotional Knowledge is Key to Investment Success
Understanding emotions and how we process information to make decisions is vital to investment success. This is true whether you manage your own portfolio or whether you have hired a professional portfolio manager to handle the task. The sad reality is that most professional money managers don’t understand that their emotional judgements are likely harmful to portfolio performance. Professional money managers are at the mercy of the investor’s behavioral biases without even realizing it. For example, if a professional money manager believes in investing for the long-term knowing that he will suffer from underperformance from time to time, he may not realize it, but when he begins to underperform his peers his clients will likely move money away from him to his competitors. This will cause him to begin focusing on short-term performance in order to keep his investors satisfied. The portfolio manager will in effect begin to suffer from the individual investor’s biases. I believe a main role for professional portfolio managers is to educate clients on the emotional and behavioral pitfalls that often cause investors to hurt themselves in the long run in regards to portfolio performance. In this white paper I will attempt to address some of our most common behavioral pitfalls.
Modern Portfolio Theory is based on the premise that investors are rational thinkers. This means that given a set of choices with probabilities, investors will choose the best option given these probabilities. This may be true in some cases, however as you read through this paper keep in mind we all suffer from behavioral biases that are good in everyday decision making situations but horrible in regards to investing decisions. The purpose is not just to understand our decision making process but to see how it affects our ability to rationally make investment decisions.
Psychologist have identified two separate modes of thinking. Keith Stanovich and Richard West refer to these two systems as system 1 and system 2. System 1 is automatic and we apply this with no voluntary control such as detecting anger in someone’s voice or making a sad face when we see something sad. These are automatic and we generally have no control over them. System 1 is what gets us in trouble when we are making investment decision based on probability. System 1 can also be learned, skills such as mathematics. When I ask you what 2 + 2 equals you likely did not hesitate one instant. It was automatic and effortless. System 2 requires attention and effort. When I ask you what 23 x 56 equals you first hesitate, then begin to work through the problem. It requires you to draw on skills you do not use every day. System 1 is generally good at making decisions based on initial reactions, however it is biased and has little understanding of logic or statistics. Both systems fight for our attention and we generally allow system 1 to overpower system 2 since we know system 2 is lazy. Here is an example of the laziness of system 2 from the book, “Thinking Fast and Slow”, by Daniel Kahneman.
A bat and ball cost $1.10
The bat costs one dollar more than the ball.
How much does the ball cost?
The first number that comes to your mind is from system 1. I am guessing that most people have guessed $0.10, which is wrong. Now that I have told you that it is wrong, your system 2 will kick in to try and figure out the true answer. The true answer is $0.05. If the bat costs one dollar more than the ball it will cost $1.05 and the ball will cost $0.05. The longer you use system 2 the more taxing it is.
We have just learned that we are susceptible to system 1 thinking and we are on average lazy thinkers. Even if we stop and force ourselves to think “rationally” we are still likely to be influenced by other biases. The next most common behavioral biases is Anchoring. If I were to walk into a classroom filled with people and holds up a jar of peanuts and ask the class to guess how many peanuts were in the jar, I would likely get answers all over the map. If right before I asked the question of how many peanuts were in the jar a random person walks in and says, “281” and then walks out of the room, I the answers I would get would fall around this 280ish number. This is anchoring. The psychological mechanisms that produce anchoring make us gullible to marketing ploys and sales people. For example, Daniel Kahneman gave the following example.
A few years ago, supermarket shoppers in Sioux City, Iowa, encountered a sales promotion for Campbell’s soup at about 10% off the regular price. On some days, a sign on the shelf said LIMIT OF 12 PER PERSON. On other days, the sign said NO LIMIT PER PERSON. Shoppers purchased an average of 7 cans when the limit was inforce, twice as many as they bought when the limit was removed. Anchoring is not the sole explanation. Rationing also implies that the goods are flying off the shelves, and shoppers should feel some urgency about stocking up. But we also know that the mention of 12 cans as a possible purchase would produce anchoring even if the number were produced by a roulette wheel.
This example shows that people purchased twice as many cans of soup just because an anchoring tactic had been employed. Anchoring is everywhere and it is extremely difficult to eliminate in investing. Warren Buffet in one of his letters to shareholders was asked how he evaluated a company’s stock and determined a purchase price. His answer was amazing. He said he did all of his analysis before he ever looked at what the company’s stock was trading for in the market. Most people probably read right past that little bit of wisdom Mr. Buffet shared. The key was that he eliminated the anchoring effect of knowing the stock price by not looking at it before he arrived at the price he thought the company was worth. By doing this his analysis was unbiased as far as anchoring is concerned. Even when we are aware of an anchor whether it is on the price of a stock or on the number of cans of soup we are limited to, we are not going to be able to know the full impact of how the anchor guides and constrains our thinking since we cannot imagine how you would have thought if the anchor was not present or was a different number. We should always assume that any number will have an anchoring effect.
Now we have background information at some of the fundamental behavioral biases we face as investors. What if I now tell you that when faced with probabilities we are risk averse in regards to gains and risk seeking when faced with a probability of losses. Consider the follow two problems put forth by Amos Tversky and Daniel Kahneman:
Problem 1: Which do you choose?
Get $900 for sure OR 90% chance to get $1000
Problem 2: Which do you choose?
Lose $900 for sure OR 90% chance to lose $1000
If you are like most people you chose the guarantee in Problem 1 and chose to gamble in Problem 2. It has been shown that people feel more pain from a loss than they do pleasure from an equally sized gain. It is interesting to know that people become risk seeking when their options are all bad.
Let us take this one step further with another Kahneman and Tversky problem:
You are offered a gamble on the toss of a coin.
If the coin shows tails, you lose $100
If the coin shows heads, you win $150.
Is this gamble attractive and would you accept it?
If you are like most people you would not accept this gamble. Is that what a rational thinker would do? Think about it for a second. The probability of the outcome is a net gain of $25. A rational investor would take this gamble all day long. However, we are loss averse by nature. We tend to hate losses much more than we like gains. The mere thought of losing $100 terrifies us and we neglect to allow our system 2 thinking to overcome the loss aversion and think rationally based solely on probability.
The last bias I will cover, so as not to write a book on the subject, is mental accounting. Whether we believe it or not, we tend to keep a mental account for the prices we have paid for things especially when it involves investing. Suppose you need $10,000 to repair a wrecked car. You have two stocks that you can choose between to sell to cover the cost of the repair. Stock A has a $10,000 gain and Stock B as a $10,000 loss. Which would you sell to cover the cost to repair the car. Many investors would choose to sell Stock A. Remember we are loss averse and the pain of selling a stock for a loss is much more painful than the pleasure we will feel by selling a stock for an equal size gain. A rational investor would sell Stock B or the stock that he/she felt would do worse going forward. If you sell Stock B and you live in the U.S. you will possibly reduce your taxes, whereas if you sell Stock A you will owe taxes on the gain. Why then would any rational investor sell Stock A to cover expenses. The answer is a “rational” investor would not. However, many investors would rather close a mental account with a gain which is more pleasurable rather than a loss which will cause pain. This is just one more example of emotions getting in the way of prudent investing.
There are many more biases we suffer from as investors such as:
My hope is that investors and clients that read this will understand that investing is much more a mental game than an IQ game. It is not the smartest people that succeed in investing it is the investors that are mentally prepared and mentally tough that succeed over long periods of time. We have all heard that investors tend to sell when they should be buying and buying when they should be selling. I believe emotions are the single largest factor that inhibit investors from living out their investment and retirement dreams. Understanding the degree to which biases affect a person’s decision is a first step, striving to conquer these biases is a life long journey.
© Perissos Private Wealth Management, LLC