There is a book that not many of you would want to read, but yet it is very powerful. It is called “The Psychology of Investing” [1]. In the book the author outlines the different behavioral shortcomings investors exhibit when investing. As human beings we are wonderful at many things, but investing is not one of them. That’s why most folks do so poorly, and leave roughly 60% [2]of the returns otherwise due to them in the Wall Street dust bin. There are 39 in total (of course we counted) and let’s cover just a few.
“Anchoring” is when we think we know an answer or have some idea of what it might be. Here’s an example; in 1896 the Dow Jones Industrial Average (DJIA) was at 40. At the end of 1998 the DJIA was at 9,181. The DJIA is a price-weighted average which means dividends are omitted from the index. If dividends had been included, what would be the value of the DJIA average at the end of 1998? Certainly you’ll have to guess, but try to be 90% sure of your answer. Go!
Whatever you might have guessed, we’re thinking you would not have guessed 652,230 [3]. Why? Well, mostly it is because you were ‘anchored’ at the 9,181 figure and were multiplying 2x or 20x that number. We asked you to be 90% sure and you therefore should have picked a pretty big number but you were stuck lower because of the anchoring effect. It happens all the time. Want another? What’s the average weight in pounds of an adult blue whale? (answer at the end*).
A second effect is “Overconfidence”. In a sampled study taken of college students, 82% rate themselves as above average in driving ability. We have here an example of the Lake Woebegone effect, where ‘all the children are above average’. In investing, people believe the stocks they own will outperform the stocks they do not own. This overconfidence is because somehow they feel that by owning a stock they have some influence over it. Combined with “Regret Syndrome” and “Disposition Effect”, we often hold on to investments that are down in price because selling at a loss would mean admitting to a mistake and we’d feel regret. The stock doesn’t owe us anything and selling would be wise, but investors have a hard time doing these things.
Lastly, “Representativeness” means we tend to believe the good performing stock or asset class will continue to be high performing, and / or the poor performing asset class will continue to be poor performing. Reality shows that this misperception in investing is dangerous. The extensive amount of market history available to us would demonstrate that regressing-to-the-mean is common, which means that market segment which is up will decline, and that which is under at the moment will revert to be higher. Psychology fools us into believing the present will continue and we don’t look back enough to assess what is likely to occur. In this sense, George Santayana was right in that “those who cannot remember the past are condemned to repeat it”.
Investing is NOT an easy task, and in the current environment it is even more challenging. However, the smartest investors are one’s who can deal with investing in spite on the emotions. They say because of these challenges and other planning contributions that advisors add 1.82% [4]per year to a client’s portfolio. Acting contrarian to our emotions is hard, but has been time and time again proven to be the right strategy. Perhaps General Omar Nelson Bradley had it right when he said; “We need to learn to set our course by the stars, not by the light of every passing ship.”
Keep the faith. The sun will come up tomorrow.
*250,000 pounds
[1] Nofsigner, John R. (Prentice Hall, 2005)
[2] 2012 DALBAR Quantitative Analysis of Investor Behavior (QAIB)
[3] ibid (pg. 4)
[4] Jaffe, Chuck, regarding Morningstar Study (2012, Market Watch)
