Rational Advisor

It seems like we’ve opened a can of worms about performance. Investors are beginning to believe that out performance means LESS risk and better investment management.

Well, our brains work in such a way that certain irrational judgments are almost inevitable, and we need to guard against them.

That is most definitely the case when looking at recent performance. Some mental traps are almost certain to cost you real money.

Anchoring is one of those mental traps, and it becomes a dangerous thing in many instances, including investing. Some examples of anchoring include incorrectly estimating expected returns based on recent performance. For instance, after a bear market like the one that occurred in stocks in 2000-2002, investors usually anchored to low returns and bad outcomes, and project poor performance in the future. On the other hand, investors in bull markets invariably overestimate average returns going forward, and underestimate risk. For a great example of this, look at the current Canadian real estate market, and oil markets. Momentum has pushed these markets to record levels and investors believe there is no end in sight.

Anchoring can be an expensive irrational judgement if it causes you to ignore opportunity in “bad” times, or ignore risk in good times. Currently many are ignoring risks.

Another important mental blind spot that investors should be aware of is probability in hindsight. The idea that hindsight is 20/20 is actually a cognitive illusion.

That has significant implication for investors who try to wrap their heads around portfolio risk. On the one hand, taking on more risk in an investment portfolio by holding a higher proportion of stocks may increase the long-term return of the portfolio. On the other hand, if the investor bails out in a downturn, returns may well be worse than if the investor had been more conservative in the first place.

Investors who talked themselves into being more aggressive because it’s “obvious” that the stock market’s trend is up may be suffering from a probability in hindsight that cannot be sustained when the near-term performance of the market is down, and it suddenly becomes equally “obvious” that the risk has returned.

Just like now, investors are thinking that it was “obvious” that the Canadian dollar would go to par and beyond, and that Oil would go to $90+, and gold to 1980’s levels.

Having watched the way investors have behaved since the Crash of ‘87, I’ve come to believe that most human beings are simply not hard-wired to be good investors. I am seeing the same thing now, as investors are getting excited/depressed about their returns and making emotional moves.

The brain is not an optimal tool for making financial decisions. The part of our brain that tells us to act like rational investors tends to be completely overtaken by much more powerful emotional impulses - impulses, that make us human.

Humans, have a phenomenal ability to detect and interpret simple patterns. That’s what helped our ancestors survive the hazardous primeval world, enabling them to evade predators, find food and shelter and eventually to plant crops in the right place at the right time of year. But, when it comes to investing, our search for patterns leads us to assume that order exists where it often doesn’t.

The bogus science of technical analysis comes out of this deep human trait - investors search for trends that are consistent and repeatable (even though they’re not). So does our need to try to predict where the market is going - something no one can possibly know. As soon as a stock seems to conform to a pattern that has made money before, an ‘I got it’ effect kicks in, making investors feel sure they know what’s coming next. But of course they don’t.

Virtually every mistake investors make has to do, in one way or another, with the way our brain has evolved. Putting far too much of our retirement portfolio in the stock of the company we work for? Neuroeconomic experiments have shown that when people put money in foreign markets, the amygdala - “one of the brain’s fear centers” - kicks in. On the other hand, investing close to home - or, better yet, in the company you are most familiar with, your own - “generates an automatic feeling of comfort.” And in this comfort we downplay the risks.

How about understanding what our real tolerance for risk is? Our risk tolerance is not a fixed thing, but changes from day to day, even hour to hour, depending on our mood. Indeed, research has shown that the way we think about risk often depends on how others have framed the question for us. Amazingly, for instance, people tend to be more sanguine about risk when it is expressed as a percentage (10 percent, say) than when it is expressed as a frequency (one out of 10). One of the things I like to stress, is that no matter what the investment, investors should expect a negative return once every three or four years. If this is not placed in your minds then you have unrealistic expectations about investing.

Humans are emotional beings, and that is always going to get in the way. What sets apart investing geniuses like Warren Buffett is precisely their ability to ignore their emotions -or, perhaps, to use them differently than the rest of us do.

I don’t think they ignore their emotions. I think they turn them inside out. When they feel fear, they don’t act on it. They examine it. They say, what should this feeling tell me? It should tell me that prices have gone down so values have gone up. So they buy stocks while the rest of us are selling. And likewise when greed sets in, prices have gone up and value has gone down. So, they would be reducing equities while the rest of us are buying.

Here’s a story about Charles T. Munger, the Los Angeles lawyer best known as Mr. Buffett’s sidekick at Berkshire Hathaway. A woman was sitting next to him at a dinner party in L.A. She turned to him and said, `You’re Warren Buffett’s partner, and a great investor. Tell me, what is your secret?’” Mr. Munger looked up at her. “I’m rational,” he said. Then he went back to his dinner.

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