INVESTING WITH CLARITY® BLOG
Biased, Who Me?… Just a Point of Reference?
October 28, 2020 2:58:22 PM
The Causes of Poor Decision-Making in Investing are NOT simply buying and selling at the wrong time; rather Poor Investor behavior includes psychological traps, triggers and misconceptions that cause investors to act irrationally. There are five broad behaviors that plague investors:
- LOSS AVERSION: Investors often expect to earn high returns while incurring little to no risk. Such an assumption is far from reality in the market, as investors must take a calculated risk to receive higher returns.
- ANCHORING: Investors are often likely to experience déjà vu in their investing experience by constantly trying to relate to familiar occurrences, even when inappropriate.
- HERDING: Even as data and various indicators warn investors against a specific investing behavior, investors herd around commonalities in the market and continue to copy one another in the face of unfavorable outcomes.
- MEDIA RESPONSE: The average investor will bask in his addiction to the news from various media sources without reasonably examining any of the headlines that are presented.
- REGRET: The average investor will continue to regret the decisions they made previously rather than focus on the decisions they are not making.
Society has turned something that is relatively intuitive into something complex and confusing. The original intent of public stock ownership was to allow ordinary citizens of modest means a chance to take advantage of the American Dream. Yet for most investors, we seem to have taken what was supposed to be simple and made it quite complicated. We love the quote from Warren Buffett that reflects how investors approach investing in great American businesses, “There seems to be a perverse human characteristic that likes to make easy things difficult.” While it is easy to blame institutions like “Wall Street” for this dynamic, who we really should blame is ourselves.
Like any endeavor, we approach investing with preconceived notions and past experiences, which causes us to misinterpret information and pushes us to regrettable decisions. The psychology world refers to this process as succumbing to our own pretenses or biases. Furthermore, scientific research gauges this phenomenon as highly difficult to break and analogous to freeing oneself from the shackles of addiction. Harry Markowitz, in his landmark Modern Portfolio Theory thesis, used the fact that he believed investors were unbiased as one of his main three pillars or tenets. In essence, investors make decisions in a vacuum, not benefiting from being able to bring previous experiences to the table. We completely disagree with this assessment and would construct a thesis using the exact opposite point. That is, all investors incorporate biases and heavily rely upon them in the decision-making process. Although there is much overlap in the definitions of investment biases, we have developed the “Dirty Dozen,” a list of the 12 biases that are the most devastating and difficult for investors to overcome. Because we are constrained in the length of our newsletter we will list the 12 Big Bad Biases and focus on the one we believe to be the most insidious.
The Dirty Dozen include the following 12 specific biases with the most devastating noted in red font known as Reference Point Bias:
Reference Point Bias - to money managers and advisors alike, this may be the most frustrating bias that investors display. Reference point bias sets expectations of performance around an extreme price level, usually a 52-week high or even an all-time high. Let’s say a money manager buys a stock at $50 per share. The stock proceeds to reach an all-time high of $75, a fifty percent appreciation from the original purchase price. Then, something fundamentally changes in the business, and the stock moves to $60/share. At that point, the money manager sells the stock, capturing a profit of 20% on a cost basis. In turn, the client becomes furious, because the portfolio manager did not sell at $75/share and deems the money manager and/or advisor incompetent. The client is never satisfied unless each position is bought at a recent low and sold at a recent high. If you or your clients struggle with this bias, we simply ask that you bring it to our attention so we can structure realistic goals with prudent return and risk expectations.
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