Investing is about Behaviour

Twenty years ago, an economist gave a speech. This is nothing earth shattering, as economists give a lot of speeches. What is remarkable though is that within that speech, two words have continued to live on. Buried in the middle of the speech, were the words “irrational exuberance”. This speech took place four years before the dot-com bubble burst which ended up costing investors $5 trillion. The economist was Alan Greenspan, who was the Chairman of the Federal Reserve Bank of the USA at the time. In 2000, four years after the words ‘irrational exuberance’ were uttered, the bubble came crashing down.

Is there such thing as a rational market? What we know through our experience in the markets, is that investing is hardly ever rational. Warren Buffett, the Oracle of Omaha famously said that investors should be buying when everyone else is selling, and selling when every-one else is buying. That in itself is a statement about the emotional nature of investing.

Howard Marks, the Chairman of Oaktree Capital Management recently made the statement that “investing is not about IN or OUT, black or white, risky or safe. Investing is about behaviour.”

Over the past year I have been doing some heavy reading in the form of two graphic novels written by Grady Klein and Yoram Bauman, Ph.D. (The Cartoon Introduction to Microeconomics¹ /Macroeconomics. ) Before anyone judges my choice of reading material, I deem it to be research on behalf of my millennial clients. Plus, they are very well written and provide a great overview of 1st year Economics. Economics is about the actions of optimizing individuals. In the eyes of economists, every individual is an optimizing individual simply because they are trying to satisfy their own prefer-ences. Economics then is the study of optimizing individuals and their interactions with other optimizing individuals. Microeconomics looks at the laws of supply and demand. Macroeconomics takes a much bigger look at issues that affect ALL optimizing individuals, such as inflation, unemploy-ment and economic growth.

For those readers who are not at all interested in finance, or economics, please stay with me just for a little bit. If economics is about the actions of optimizing individuals (trying to satisfy their own preferences) then behavioural economics tries to provide an explanation for why people make irrational financial decisions. If you have never fallen victim to making an irrational financial decision, then you are not likely being honest with yourself. We all fall victim to making irrational decisions, most likely because we submit to 1) rules of thumb or mental shortcuts, 2) poorly framing the issue at hand and thereby using emotional filters to understand and respond to events, 3) or falling victim to market inefficiencies such as mispricing a good or service or make non-rational decisions. (See: 11 Emotional Hurdles that could be killing your portfolio).

A good example of this is the Facebook app and the ‘like’ button. How much more often do you ‘like’ something if a whole group of other people have ‘liked’ something, as opposed to being the first to ‘like’ something? If you have been hearing the financial news, you will know that the Dow Jones Industrial Average just topped 22,000 for the first time in history. This achievement is no less amazing since the Dow Jones Industrial Average crossed 20,000 and then 21,000 for the first time ever since the beginning of 2017. At the start of the year, the DJIA was at 19,872 and is now at 22,010 (or up 22.83%) on the year.

The US markets, including the Dow Jones Industrial Average, S&P 500 Index and the Nasdaq Composite Index have been outperforming global markets but this is based on the influence of a smaller subset of stocks, namely the companies known as FAANGs; Facebook, Apple, Amazon, Netflix, Google. To put these companies into context, FAANGs have a market capitalization of $2.41 Trillion which is about the size of the entire economy of France and just over 13% of the US economy. The S&P 500 Index is up 9.96% year-to-date and yet if we take the FAANGs out of the S&P 500 list, then the S&P 500 Index would have only gained 1.4%.

Why is this important? There is another “economist” known to most Canadians who said “I skate to where the puck is going to be, not where it has been.” While that seems like a great quote, the Great One also said; “Ninety percent of hockey is mental and the other half is physical.” Ok, so Wayne was a great hockey player and not the best economist, but I hope you get the point. For the past 6 years, all focus and attention has been on the US stock market. Now, all eyes and ears may still be on the US but this is more likely due to the ‘reality T.V show’ going on in the White House.

The following chart (next page) caught our attention last week. Thanks to our friends at RBC Global Asset Management, who provided us with an update on the RBC Quantitative EAFE Dividend Leaders ETF (RID:TSX) held by many of our clients. The following chart shows how the MSCI EAFE (Europe Australasia Fare East) Index has been quietly performing despite many negative headlines and realities. Just like the US market began to emerge from the financial crisis 7 years ago despite many negative headlines, the European markets seem poised to begin to quietly perform.

While one chart may not make a full case, it caught my attention simply because it consolidated the information that we have been receiving from multiple sources and institutional managers stating the case for the expansion of investment portfolios outside of the US.

You may be asking; why the introduction to behavioural finance and economics? With the recent outperformance of the S&P 500 Index and the Dow Jones Industrial Average, it may be easy to fall prey to two emotional hurdles: The Bandwagon Effect and Recency Bias. With the poor performance on the EAFE markets over the past three years, it is also just as easy to fall victim to Loss Aversion, Anchoring or the Endowment Effect. Lastly, for so many investors who continue to believe in the bond bull market, the emotional hurdle of the Disposition Effect may delay or prevent bond investors from taking profits.

It is my opinion that one of the greatest strengths of independent investment advisors, like us, is that of being able to handle the emotional roller-coaster of investment markets. We are hardly emotionless advisors, but in order to deal with the realities, we are best at what we do when we recognize and admit our own biases and counteract the emotional hurdles which we too encounter. This is the benefit of completing an Investor Profile Questionnaire on a regular basis (3 year average) to be most aware of your own investment objectives, risk tolerance and time horizon. It is also just as important to know your advisor’s tolerance for risk.

As for me and my family’s portfolio – I prefer a more globally diversified approach. It helps me sleep at night. For the reading pleasure of some, please see excerpts from ‘The Cartoon Introduction to Economics’. For my kids living on their own this year, please see “Tragedy of the Commons” and kitchens and dorms. It may save your life, or at least encourage your mother to visit..

11 Emotional Hurdles that could be killing your portfolio: 4

  1. The Bandwagon Effect; This is the one that causes the most pain in a bubble. It’s the idea that it’s okay to follow the herd because so many other people believe in it. It’s irrational because it places faith in the safety of numbers, while completely disregarding the fundamentals. Without it, a bubble is impossible.
  2. Loss Aversion: People tend to have a strong preference for avoiding losses over acquiring gains. It’s the fear that puts them on the sidelines to stay.
  3. Disposition Effect: This is the tendency for investors to lock in gains and ride out losses. It prompts the sale of shares that are rising, while it also keeps investors tied to losers for far too long. It’s closely tied to loss aversion, since it’s the fear of loss that dominates the thinking.
  4. Outcome Bias: Judging a decision by its outcome, rather than the quality of the decision at the time that it was made. This is what makes investors completely disregard a proper decision if it turns out to be a loss.
  5. Sunken Costs Effect: Treating money that has already been spent as more valuable than money that may be spent in the future. It’s what helps to build up losses because the investor believes that by selling at a loss, he is wasting money. That same money could be put to use elsewhere.
  6. Recency Bias: Weighting recent data more heavily than earlier experiences. It’s what freezes investors, especially after a series of losses, even though there may be a much longer string of successes in the past.
  7. Anchoring: This is the tendency for people to rely too heavily on readily available information when making a decision. Investors often base their decisions on information that may be faulty.
  8. Belief in the Law of Small Numbers: This is when investors base their conclusions on a slice of data that is too small. It’s the equivalent of making mountains out of molehills, and it blurs reality.
  9. Endowment Effect: People tend to value something more once they own it. As in housing, people tend to overvalue what belongs to them. Of course, this only blinds to them to the real value.
  10.  Disconfirmation Bias: This makes people critical of information which contradicts their beliefs, while un-critically accepting information that is in line with them. In short: it’s a trap whereby people believe what they want to believe.
  11. Post-Purchase Rationalization: This is when investors persuade themselves through rational argument that a purchase was a good value. Of course, if a decision needs to be rationalized after the fact. . . it was probably wrong.

1 The Cartoon Introduction to Economics, Volume One: Microeconomics, G. Klein & Y. Bauman, PhD.
2 The Cartoon Introduction to Economics, Volume One: Macroeconomics, G. Klein & Y. Bauman, PhD.
3 Interactive Data (Market-Q)
4 Steve Chris, The Wealth Advisory: The Eleven Emotional Hurdles that could be Killing your Portfolio (August 2009)