We have a world experiencing turmoil and stress, from the Far East to the Mid-East to the expected extra Yeast at the Thanksgiving feast.  All of those points of human interaction that occur on a global or personal scale can bring conflict, or in fact are already in conflict.  Investors think that these events commonly determine the outcome of their portfolios and whether they will be successful financially in life.  That’s not true, and today I address the 5^th in the series on the “Top 7 Steps” that separate winners from losers.  We focus on the primary conflict that must be controlled: In a nutshell, it is you. If you want to be financially successful you must control the hardest to control variable out there; YOU, and the space between your ears.

In my years of research, I have learned of thirty-nine (39) major psychological mistakes that investors make, mistakes which short-circuit their financial lives.  You would be wise to recognize these mis-portrayals acting in your life or the monetary soap operas will re-run themselves.  Some mistakes are emotionally driven, but many are the result of the millions of years of our development as human beings.  These mental heuristics, our brain’s way of efficiently processing thousands of inputs simultaneously, are natural to us.  Thus, while it is true that we were created to be good at many things, being a good investor is not one of them.

Let me start this session by posing this question:

“How good of a driver are you?  Compared with drivers you encounter on the road, are you above average, below average, or average?”

If overconfidence was not involved, roughly 1/3^rd of Americans (you) would answer above average, 1/3^rd average, and 1/3^rd below average.  However, people are overconfident in their abilities.  In one published study, 82% of sampled college students thought they were above average.[i]

Misjudging your driving prowess may not cost you money, but it likely does in the financial world.  “Overconfidence Bias” is a phenomenon in investing that commonly hurts return performance because investors trade too much, or inappropriately concentrate their risks.  Overconfident investors simply misinterpret the level of risk they take on.  Commonly they think the new stock they have researched is a smarter choice than the one they hold, so they sell one and buy the other.  If we study turnover (the established term for the buying and selling of securities) in individual investor accounts, which would be a natural semblance of overconfidence due to the above reasons, we can measure how well it works out.  Two iconic researchers from Berkeley studied thousands upon thousands of investor accounts and I’ll give you just three of their observations:

1. The highest turnover group (top quintile) experienced a dramatic 38% lower return than the lowest group.[ii]
   
2. Stocks sold earned 2.6% during the following 4-months, whereas the replacement stocks earned only 0.11%.[iii]
   
3. Not to add fuel to the ladies fire, men are more overconfident than women, leading to higher levels of trading.[iv]

What are some other common psychological mistakes that we see?  In interest of time, let me just share four more.

1.  There is the “Snake Bite Effect”. After experiencing a loss, people become less willing to accept a risk.[v]  If people lost money in 2008 when the S&P 500 dropped 56% and got out of the market, some unfortunately stayed out of the market fearing being bitten again.  An expensive error?  You betcha.  No matter how you do the math, the market is up 300% – 600% since then (12,000 on the Dow Industrials to 43,000 now).
   
2. Nearly opposite the above, we have the “House Money Effect”.  After investors have experienced a gain or profit, they are willing to take more risk. They put their fanny on the line originally with their own money, but view their gains as not really money in their pocket (or at least, not as equally valued).  An analysis done at the horse track found gamblers are less likely to take larger risks at the beginning of the day, say on 15 to 1 odds.  However, at the end of the day, winners take this risk as though they are playing with the house’s money.[vi]  And…they feel more confident moments after walking away from the betting window than they did standing in line to place the bet.[vii]
   
3. “Familiarity Bias” occurs when we think of a particular investment more favorably than the alternatives because it is closer to us, whether that be meant emotionally, psychologically, or geographically or some combination thereof.  In 1984 AT&T was broken up by the government into seven regional phone companies, who in common vernacular became known as the Baby Bells.  Twelve years after the break-up, it was found investors were more likely to invest in their local ‘Baby’ than the phone company in another region[viii], regardless of the local Baby Bells performance.  Similarly, in a study of 246 of America’s largest companies, 42% of the employee’s 401k assets were invested in company stock of their employer.[ix] [x] There is comfort in having your money invested in a business that is visible to you, but there is not necessarily wisdom in it.  Never forget this truism; You may love a stock…but the stock does not love you back.
   
4. Let me conclude with the human frailties seen in the “Disposition Effect”.  On average, investors are 50% more likely to sell a winner investment than a loser.[xi]  Though the IRS tax code preferences selling losers, we don’t do it because we would then have to consciously admit we made a mistake – which is painful to us.  This psychological shortcoming is often reinforced by another phenomenon known as “Regret Avoidance”.[xii] Either way, we find investors rationalizing suboptimal behavior.

Money and investing should be objective decisions, but as we see in the examples demonstrated above, we must confront the fact that we are human beings.  We are unfortunately not the ‘rational beings’ that seminal finance and utility preference theories modeled in the early days.  Doing investments well means controlling a lot of variables, but the biggest variable to control – IS YOU.  From my chair, a good advisor works smartly to keep your investments going up while keeping you settled down.

It remains my deep and distinct honor to serve you.

Patrick Zumbusch
Founder and CEO

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[i] “Are We All Less Risky And More Skillful That Our Fellow Drivers?” (Ola Svenson, Acta Psychologica, 1981)
[ii] “Do Investors Trade Too Much?” (Brad Barber, Terrance Odean, American Economic Review, 1999)
[iii] “Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance Of Individual Investors” (Brad Barber, Terrance Odean, Journal of Finance, 2000)
[iv] “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment” (Brad Barber and Terrance Odean, Quarterly Journal of Economics, 2001)
[v] “Prospect Theory: An Analysis Of Decisions Under Risk” (Daniel Kahneman, Amos Tversky, Econometrica, 1979)
[vi] -ditto-
[vii] “Post-decision Dissonance At Post Time” (Robert Knox, James Inkster, Journal of Personality and Social Psychology, 1968)
[viii] “Familiarity Breeds Investment” (Gur Huberman, Columbia University, 1999)
[ix] “Color Tile Offers Sad Lesson For Investors In 40k Plans” (E. Schultz, Wall Street Journal, June 5, 1996)
[x] “Workers Put Too Much Money In Their Employers Stock” (E. Schultz, Wall Street Journal, September 13, 1996)
[xi] “The Disposition Effect in Securities Trading: An Experimental Analysis” (Martin Weber, Colin Camerer, Journal of Economic Behavior and Organization, 1998)
[xii] “Myopic Loss-Aversion and the Equity Premium Puzzle” (Schlomo Benartzi, Richard Thaler, Quarterly Journal of Economics, 1999)