Tuesday, April 23, 2013

Why We Are Lousy Investors by Guest Blogger Robert Klemkosky

 We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.

In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.

We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.

Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.

There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors  hate to admit mistakes which include stock market losses, so there is also regret aversion.

Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.

Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.

When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s  why we take credit for our successes and blame others for our failures.

Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.

People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.

Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.

Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.
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10 comments:

  1. Sound advise...especially for those of us who have limited amounts to invest and "must" see a return greater than inflation or at retirement we will be helping the homeless guy peddle pencils at the local street corner...is that fear?

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  2. Dear LSD and thank you Professor Klemkosky. I’m a simple guy but I unnerstand your stuff, or at least the gist of it, which I take is intended for simple folks that unnerstand yer stuff. Most folks, I think, though, are simple, and don’t get and cannot get yer stuff. Even college-edukated don’t git the fundamental concepts you present. Too bad. Wasted education and big debts to pay for learning that will git’m nowhere—certainly not a job that will pay enough to pay the edukation debt, pay for living expenses, and pay for retirement. Too bad. Too bad de govomit has allowed—no, actually, promoted debt over saving.

    So, all the financial and econ theory is good stuff, but in practice it’s wasted. The bottom line—not to be punny or cute—but given the reality and solidarity of the situation—the financial and (ill)knowledge bubble that is about to burst—that we as a country are spending and borrowing way above our pay grade—will make the ’07-’08 meltdown look like play dough.

    Investors (yo, even “knowledge” investors) are panicked—fixed investments return nil—equities are on a roller coaster—M&A are ping-ponging—and the Fed’s ATM machine is working overtime—the dollar’s value is steadily declining. ECB, WB, and Euro-financial schizophrenia is prolonging the collapse of the EU and euro. So, who’s gunna be left standing when the music stops? All of us who unnerstand the inner workings and hidden mechanisms of econ and financial theory might survive—assuming we’ve stashed away enough stash—but what about those who didn’t? Wut econ/financial theory will take care of them? Can you say Obummer et al?

    It would be more enjoyable to put a rosy spin on all of this, but I can’t. I thank you for your detailed presentation, but I believe it’s irrelevant to the uninformed, intellectually lazy, Dancing With The Stars, New Jersey Housewife, Dawg Ambulance Chaser, food stamp, and Unearned Income et al crowd that don’t care.


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  3. Dear Charles -- yes there is much risk and yes there are plenty of scary problems bubbling through. Yes there are a lot of people who never will be able to make use good financial or economic advice. But I doubt Prof. Klemkosky was thinking about those people. For those who do have some money invested and want to improve their results -- he brings in some interesting psychology to help. Indirectly Klemkosky's advice helps a lot of people beyond the individual investors. Keep in mind that there are many pension funds that manage money for millions of people who might not have a clue what to do with their accumulating money. As managers of these funds become more knowledgeable about behavioral finance, perhaps even the uniformed will benefit from this kind of article.

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  4. Good, common sense stuff here! I'm not immune to panic. I have several attacks of it everyday just for fun. I am moderately risk averse, but I find that at my age, just getting out of bed in the morning is gets riskier. As a "non-professional" investor, I chose to hire a professional to do my investing. He's worth the fees I pay him. I suppose it's easy to "play" with somebody else's money, but he has accurately assessed my risk tolerance and has made me a nice pile of that stuff from the Fed's ATM. I wish I had sought his advice when I was trying to self-manage my 401K just after 9/11. (Moving funds around while under the influence of panic doesn't work very well. A bottle of JD would probably have been more beneficial.)
    I will likely assume room temperature before my pile is exhausted.

    The long-haul is what it's all about. After all, even in that fiasco called the Carter Economy, the markets trended up.

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    Replies
    1. Fuzz, I have always been buy and hold Larry. Market timing is for the birds. It looks great when it works but that just sets most folks up for the big slam...ouch.

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  5. Dear Fuzzmeister and LSD. Gentleman and Prof. Klemkosky concluded with, “Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.”

    But you two all but admitted that yer investing criteria don’t factor behavioral factors only that yer in it fer the long haul—being “long”—investment wise; not other. I guess yer hoping yer investment advisors adhere to Prof. Klemkosky’s behavioral stuff rather than the commissions they git from your investments.

    Admission: I, too, pay “professional” fees, finally acknowledging that I can’t unnerstand all the inner workings and hidden mechanisms of investing. The opportunity cost got me down—either manage the retirement doo-da 24/7 or watch the View, Gilligan’s Island, Gun Smoke, Leave It to the Beav, Hazel, et al. At this point, I can’t say which provided the best return . . . . but, hey, wut’s the opportunity cost of investing a few digital coins here and there when the Fed ATM is woik’n OT?

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  6. Chuckster, since my pro is using mine and other folks' money, I'm pretty sure panic doesn't affect him too much. Greed might play a small part, but he's going to get his percentage regardless. If I call him up tomorrow and tell him that I want him to throw caution to the wind, he may wince a bit, but he'll start investing in the Fiskers, Solyndras, and those other high-risk investments. So while he's doing the heavy lifting, I'm pretty sure he's not overly influenced by Prof. Klem's behavioral stuff. Not nearly as much as if I were actually doing the investing myself.

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  7. Charles,

    God catch. Looks like Fuzzy weighed in. I would only add that while I value the behavioral insights of Prof. Klemkosky -- I don't necessarily follow them. His approach is still under the heading of market timing. It is traditional market-timing plus psychology. But I don't believe in any form of market timing. I think you just lose in the end. I just put money away for the future and if I want something available in the near future then I invest it in a money market account or some other very riskless asset. I think it is fine that other people market-time -- it just isn't my cup of tea (arsenic).

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  8. Fuzz Meister says
    “Chuckster, since my pro is using mine and other folks' money, I'm pretty sure panic doesn't affect him too much. Greed might play a small part, but he's going to get his percentage regardless. If I call him up tomorrow and tell him that I want him to throw caution to the wind, he may wince a bit, but he'll start investing in the Fiskers, Solyndras, and those other high-risk investments. So while he's doing the heavy lifting, I'm pretty sure he's not overly influenced by Prof. Klem's behavioral stuff. Not nearly as much as if I were actually doing the investing myself.”

    El Chuck’o says
    Fuzz Meister—you scare me. So far only my wife calls me Chuckster—have you two been doing mind-melds? Gotta say I luv yer sarcasm—you jokester you—implying your pro wud invest in Obamadom’s Fisker, Solyndra et al should you give him the green light (pun on green unintended, BTW).

    Dr. LSD . . . you seem too grounded investing in monkey-market accounts et al. Shure, yank all those greenbacks out when you want to go crazy at CostCo—spurge, make the 4th year of Joe Biden’s summer of recovery a reality . . . . go fer it, baby. Yer cup o ‘tea . . . really . . . more like a 64-oz refill of JD that probably Bloomberg would OK since it wouldn’t contain empty calories derived from Coca-Cola et al.

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  9. Live long and prosper, Chuckster!

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