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These Behavioral Biases Are Driving Investor Decisions

By Rupert Hargreaves. Originally published at ValueWalk.

Watch out for historical bias

Some might say that Greenrock Research’s third quarter 2017 (yes the company calls it Q3, not Q2) Investor Insights newsletter (as reviewed by ValueWalk) is pessimistic. More experienced investors might say that the note strikes an appropriately cautious tone for the current environment. Whichever camp you fall into, the central message of the newsletter should not be ignored: Investing is tough.

The note begins with a reference to Michael J. Mauboussin’s book, Think Twice in which he argues that it is human nature to simplify problems, preventing us from making sound judgments when confronted with complex problems. Investing is a complex problem, and trying to streamline the process could be the biggest mistake investors make.

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Unfortunately, investing simplification is rife today and it has been since the beginning of time. The history of markets reflects the instinct of investors to follow whatever the current trend may be. In some ways, this is a simplification of the investment process as investors are looking to do as little work as possible in order to make the greatest gains. In 1998 the top 12 stocks contributed all the return of the S&P500 and in the later 1960’s and early 1970’s a group of stocks called the Nifty Fifty controlled and then pummeled the market (only time will tell if the same scenario unfolds today.)

Investing is a complex problem and thinking twice to consider reasonable time frames for investment success is vital if you don’t want to get caught up in the wrong time frame, e.g. chasing the market higher with a few glory stocks.

historical bias historical bias Present Bias
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Present and Historical bias Are Driving Investor Decisions

Today it’s harder than ever to ignore the rest of the market, focus on your own time frame and process. The amount of information out there confuses and misleads. As Greenrock’s note opines “when they hear that their 6% or 7% or 8% return for the first six months of 2017 could have been 14% just by investing in EAFE, they feel as if they missed out.” The feeling of missing out can deter investors from their long-term investment goals to seek short-term “wins”, a costly distraction in the long run.

There are two psychological biases that lead to bad investment decisions according to Greenrock. The first is historical bias, which is “a way of rewriting history by believing whatever trauma occurred was not as bad as it really was.” From 2000 to 2002 the S&P 500 fell 37% and from November 2007 to February 2009 the S&P 500 fell 50.9%. A large percentage of investors today were not around to experience these declines and many of those who recalled the periods as “less painful” than they were at the time. Falling victim to this historical bias could lead to you making the same mistakes twice.

The second bias is “present bias” or the belief that the good things we are experiencing today “will continue for an extended period”. When combined with historical bias, present bias forms a toxic combination that leads to unrealistic optimism without “any thought of other possibilities”.

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Present and Historical bias aside, we think there is a third more dangerous one

These two biases in themselves are bad enough but there’s a third bias, Deprival-Super reaction Syndrome, which when combined with present and historical bias can really cause problems. Charlie Munger discusses Deprival-Super reaction Syndrome in his famous speech Human Misjudgment Revisited. Put simply, this syndrome is a psychological tendency for investors to become scared after a minor increment down, more so than a similar incremental gain in the opposite direction. People with historical bias also have a tendency to feel super deprived if something is taken away from them that was almost real but never actually possessed (such as pensions).

Today investors are faced with an uncertain environment. One of the longest bull markets in history continues, active managers are underperforming, the majority of the market’s gains are stemming from just five stocks (as was the case in late 60s and 90s) and value, which has traditionally outperformed is now struggling. Against this backdrop it’s no surprise investors are turning to passive funds, essentially giving up any hope that they will be able to outperform. (It remains to be seen what impact this shift from active to passive will have when the next bear market finally emerges.) Driven by historical and present bias investors are indexing, believing the current benign market environment will continue forever, neglecting more defensive equities.

Considering the environment, Greenrock has focused its equity strategy on dividends. Research conducted by Jeremy Seigel, tracking the companies that contributed the most dollars to the dividends of the S&P 500, shows that since the inception of the index, such a strategy would have produced returns 22% higher than the wider benchmark. This strategy isn’t a sure thing, however. While it produces returns higher than the benchmark over time, there are long periods of underperformance, but over time, the strategy comes out on top. As growth has prevailed over the past 10 years, this strategy has underperformed. Nonetheless, considering the data that backs it up, it’s only a matter of time before outperformance returns.

The conclusion from the firm is worth a read, they state:

Yes, it is true that investing is a difficult business, and anyone looking for certainty will be sorely disappointed. In addition, there are all kinds of absurd ideas being passed off as good investment theory, and they are simply explanations of what is working today. Good investing requires a thoughtful, long?term approach, but that does not mean that living through periods when that thoughtful approach is underperforming is easy. It may be part of everyone’s investment life, but it is tough. And, that is why we need to “think twice”.

The post These Behavioral Biases Are Driving Investor Decisions appeared first on ValueWalk.

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