Psychology of Investing

Psychology of Investing

 

 

“The world makes much less sense than you think. The coherence comes mostly from the way your mind works.”
– Daniel Kahneman, Thinking, Fast and Slow

“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
– Charlie Munger, Berkshire Hathaway

 

In its most basic form, investing involves allocating money with the expectation of some benefit, or return, in the future that compensates us for the risk taken by investing in the first place. Investing is a decision: buy or sell, stock A or stock B, equities or bonds, invest now or later. But as the great Charlie Munger reminds us above, investing is far from easy. Prior to making an investment decision, we create statistical models, build spreadsheets, use fundamental and technical analysis, gather economic data, and analyze company financial statements. We compile historical information to project future return and risk measures. But no matter how much information we gather or the complexity of our investment process, there isn’t one rule that works all the time. Investing involves so much more than models and spreadsheets. It is an art rather than a science that involves humans interacting with each other—for every buyer, there is a seller. At its core, investing is a study of how we behave.

Daniel Kahneman and Amos Tversky are famous for their work on human behavior, particularly around judgment and decision making. Judgment is about estimating and thinking in probabilities. Decision making is about how we make choices under uncertainty (which is most of the time). Kahneman won the Nobel Prize in Economics for their work in 2002, an honor that would have certainly been shared with Tversky had he not passed away in 1996. Their findings challenged the basic premise under modern economic theory that human beings are rational when making judgments and decisions. Instead, they established that human errors are common, predictable, and typically arise from cognitive and emotional biases based on how our brains are designed.

In his book, Thinking, Fast and Slow, Kahneman describes our brains as having two different, though interconnected, systems. System 1 is emotional and instinctive. It lies in the brain’s amygdala and uses heuristics or “rules of thumb” to simplify information and allow for quick gut decisions. In contrast, System 2 is associated with the brain’s prefrontal cortex. It is slow, deliberate, and calculating. As an example, if I write “2 + 2 =”, your mind without any effort will come up with the answer. That is System 1 at work. If I write “23 x 41=”, your mind most likely switches over to the slower moving System 2. While Systems 1 and 2 are essential to our survival as humans, Kahneman found that both systems, and how they interact with each other, can often lead to poor (and sometimes irrational) decisions. We can apply much of what Kahneman and Tversky discovered to investor behavior. Let’s focus on some of the most common biases and how they impact our decision making.

Loss Aversion

Kahneman and Tversky summarized loss aversion bias with the expression “losses loom larger than gains.” The key idea behind loss aversion is that humans react differently to gains and losses. Through various studies and experiments, Kahneman and Tversky concluded that the pain we experience from investing losses is twice as powerful as the pleasure we get from an equivalent gain. This can lead to several mistakes, such as selling winners too early for a small profit or selling during severe market downturns to avoid further losses. Loss aversion, if left unchecked, can lead to impulse decision making driven by the emotions of System 1.

Confirmation Bias

Confirmation bias leads people to validate incoming information that supports their preexisting beliefs and reject or ignore any contradictory information. In other words, it is seeing what you want to see and hearing what you want to hear. As investors, we are prone to spending more time looking for information that confirms our investment idea or philosophy. This can lead to holding on to poor investments when there is clear contradictory information available.

Hindsight Bias

Hindsight bias is very common with investor behavior. We convince ourselves that we made an accurate investment decision in the past which led to excellent future results. This can lead to overconfidence that our investment philosophy or process works all the time. On the flip side, hindsight can lead to regret if we missed an opportunity. Why didn’t I buy Amazon in 2001? Why didn’t I sell before this bear market? As I always say, I would put the results of my “Hindsight Portfolio” up against Warren Buffet’s any day!

Overconfidence

As mentioned above, investors can become overconfident if they have some success. This can lead to ignoring data or models because we think we know better. As Mike Tyson said, “Everyone has a plan until they get punched in the mouth.” Overconfidence can lead to a knockout, and investors must be flexible and open with their process.

Recency Bias

Recency bias is when investors emphasize or give too much weight to recent events when making decisions and give less weight to the past. This causes short-term thinking and allows us to lose focus on our long-term investment plan. It essentially explains why investors tend to be more confident during bull markets and fearful during bear markets.

 

I could write an entire book on investor psychology. The bottom line is that we cannot eliminate these biases. After all, we are all human. Even Kahneman, who made the study of human behavior his life work, admits he is constantly impacted by his own biases. However, there are certain actions or “nudges” that can help address such biases and avoid making costly mistakes. At Merriman, we have built the firm in such a way to use our knowledge about human behavior in the work we perform for our clients. Below are some of the main examples:

Evidence-Based

We build and design our investment strategies based on academic data going back hundreds of years. We are evidence-based rather than emotionally-driven investors. We think long term and do not let short term noise or recent events impact the process. We build globally diversified portfolios across different asset classes to produce the best risk-adjusted returns. That said, we are consistently researching and studying to find data that might contradict our investment philosophy and will make changes if the evidence supports it.

Financial Planning

A well-built financial plan is at the core of our client’s long-term success. It is a living document that requires frequent updates based on changes in our lives—retirement, education funding, taxes, change in job, business sale, and estate planning. This forces us to make investment decisions based on the relevant factors of that plan and not on emotions—because at the end of the day, investing is meant to help reach our goals.

Education

At Merriman, we do our best to help educate our clients on our investment philosophy. Blogs, quarterly letters, seminars, client events, and video content are all examples of tools we use to educate our firm and clients. Knowledge and awareness are powerful tools to help us make sound decisions.

 

We are all going through an extremely stressful situation right now—both personally and professionally. Now, more than ever, we need to lean on each other and show empathy and support through this unprecedented time. Remember, investing is a study of how humans behave. At Merriman, we want to be your resource to guide you through both calm and turbulent markets, helping you reach your financial goals. Please don’t hesitate to contact us if you’d like to discuss how we can help.

 

 

Debt Repayment: Alleviate your money from its obligation to the past

Debt Repayment: Alleviate your money from its obligation to the past

There is a good chance you, or a close family member, carry debt. It’s common for the typical American household to carry amounts exceeding six figures (Tsoie & Issa, 2018). Debt can be mysterious in the sense that individuals might owe a similar amount, but perspectives on how to repay debt vary dramatically. Debt is also not always negative and can provide strategic benefits in your financial plan. Consider a home mortgage for example, the underlying asset is likely to increase in value. Mortgages often offer a valuable source of leverage, but loans on depreciating assets like cars can quickly end up with negative equity. Other loans, like high interest credit card debt, can be especially menacing.  This article will focus on consumer debt repayment and we will highlight a few common approaches to help the borrowers make real progress on eliminating debt.

Many households across the country have debt related to auto loans, credit cards and even personal loans. The decision to take on debt is personal and the need or desire for debt means different things to just about everyone. Below are some common questions to consider when developing a debt repayment plan.

  • How do you organize debt?
  • Which debt should be paid first?
  • Should debt be paid off ahead of investing for retirement?

One strategy that many people find effective for debt elimination is using rolling payments. Rolling payments involves focusing on aggressively paying off one loan at a time, while making the minimum payments on other debt. With rolling payments, you throw as many excess dollars in your budget as possible toward repaying one loan. Once the target loan is paid off, roll that loan payment into paying off the next debt beyond the monthly minimums. Keep rolling your payments to the next loan on your list until the ball and chain of your bad debt is paid in full. To illustrate a couple different ways to prioritize your debt list, we are going to look at three approaches for prioritizing debt, including, an interest rate approach, a behavioral approach and a combination strategy that factors in retirement savings.

When evaluating debt repayment from an interest rate approach, order all debts from highest interest to lowest, and attack the highest rate first. Focusing on interest rates makes sense because you are reducing the debt with the highest interest rate drag. Although progressive, the downside to this approach is that it might take months or even years until you finally check a loan off your list. Many people become worn out and lose motivation to follow the plan. There will also be cases where a loan with a lower interest rate, but larger balance will be more impactful on the overall repayment plan than a small loan with a higher rate. However, prioritizing debt strictly by interest rates ignores that.

Interest Rate Approach Example

Let’s meet Steve, who has three outstanding debts. Steve has student loans totaling $22,000 at 6%, a car note of $15,000 at 3.5% and $8,000 of credit card debt at 17% annual interest. Utilizing the interest rate approach, Steve will prioritize his debts according to the table below and use the rolling payment method, we discussed for repayment.

Illustrating the Behavioral Approach

Now let’s consider Steve’s situation from the behavioral approach. This behavioral method prioritizes starting with the smallest loan regardless of interest rates. Compared to the interest rate approach, you will likely end up paying more interest overall with the behavioral strategy, but the small wins along the way provide motivation and reason to celebrate. This method has been popularized by the personal finance personality, Dave Ramsey, who consistently recommends focusing on behavior. He refers to this approach as the “debt snowball”. You can still take advantage of rolling payments with the behavioral strategy, so once each loan is paid off, roll the payment to the next debt on the list.

Combining Perspectives: Debt Repayment and Retirement Savings

The power of compounding interest reveals its best to contribute early and often towards retirement savings for maximum growth. If your debt is not too overwhelming, it can be valuable to continue retirement savings while paying down loans. With this in mind, we can utilize a combination approach that addresses both debt reduction and retirement savings. One method is to target either a specific debt reduction or savings goal. Use your primary goal as a minimum benchmark then throw as many extra dollars in the other direction (debt or savings) as possible. Combining goals of retirement savings and debt elimination is best utilized when loan interest is less than the expected return of investments for retirement. Focusing on both savings and paying off debt can be helpful for identifying opportunities to “beat the spread” by investing versus paying off debt.

No matter how you decide to repay debt, take comfort in knowing the best strategy is one you can commit to and stick with during tough times. Here at Merriman, we believe in the power of committing to a sound plan for guidance throughout your financial life. If you’re lost on where to start, please take a few minutes to read First Things First by Geoff Curran, which provides a guide toward prioritizing your savings. If you have questions or would like to learn a bit more, please contact a Merriman advisor who can help navigate your specific situation.

 

 

References:

Tsosie, C., & Issa E.E. (2018, December 10). 2018 American Household Credit Card Debt Study. Retrieved from https://www.nerdwallet.com/blog/average-credit-card-debt-household/

Lessons From The Lost Decade (2000-2009)

Lessons From The Lost Decade (2000-2009)

“Past performance is no guarantee of future results” is a required compliance disclosure used by money managers when reporting performance. Unfortunately, it is truer in the world of investments than almost anywhere else. When you find a 4.5-star restaurant on Yelp, there is a high probability that you will have a positive experience. Statistically, funds that had the best performance over the past three years (or one year) are no more likely to outperform the following three years than any other fund.

The same is true at the portfolio level. In the late 1990s, U.S. growth stocks were the best performing asset class and investors flocked to the S&P 500. We introduced the Merriman MarketWise All-Equity Portfolio in 1995 in the middle of this period. After the first five years, the cumulative return of the Vanguard 500 Index Fund was more than 2.5 times that of MarketWise, as Figure 1 shows. What happened over the next decade from 2000 through 2009? The exact opposite.

 

Over the tumultuous decade from 2000 to 2009, the MarketWise All-Equity Portfolio (after fees) was up 70% compared to the Vanguard 500 Index fund which had lost -10%, as Figure 2 shows. That 10-year period during which the S&P 500, cumulatively lost money is commonly referred to as the lost decade. It was a painful period for many investors. Their faith in the S&P 500 had been strengthened by nine straight years of positive returns (six years exceeded 20%) and by watching it outperform major indices around the globe.

While it was a difficult period, the investors who suffered most were those who switched investments based on past performance. Figure 3 starkly illustrates the effect of “chasing” good recent performance. The blue and orange lines show the cumulative returns of the MarketWise All Equity Portfolio and the Vanguard 500 Fund. The gray line shows the cumulative growth of funds invested in the MarketWise All-Equity Portfolio from the 1995 inception through 1999 and then in the Vanguard 500 fund from 2000 through 2009. While after fees, the MarketWise All-Equity Portfolio slightly outperformed the Vanguard 500 Fund, investing in either approach yielded solid growth. The investor who switched from MarketWise to the Vanguard 500 Fund at the top of 1999 ended up with less investment growth than the investor who stuck with either strategy throughout the whole period.

2009 to 2017 the S&P 500 again delivered nine straight years of positive returns and outperformed most major world indices. In 2018, the index was down -6.6% but has quickly rebounded in 2019. No one knows what the next ten years will bring. History suggests that past performance is no guarantee of future results and that tides turn, but when that will happen is anybody’s guess.

IMPORTANT DISCLOSURES: The performance results shown are for the Merriman-managed MarketWise All Equity (100%) Portfolio and the nonmanaged Vanguard 500 Fund, during the corresponding time periods. The performance results for the MarketWise All Equity Portfolio do not reflect the reinvestment of dividends or other earnings, but are net of applicable transaction and custodial charges, investment management fees and the separate fees assessed directly by each unaffiliated mutual fund holding in the portfolios. The performance results do not reflect the impact of taxes. Past performance is not indicative of future results. No investor should assume that future performance will be profitable, or equal either the previous reflected Merriman performance or the Vanguard 500 Fund’s performance displayed. The S&P 500 is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market. The Vanguard 500 Fund is a core equity index fund that offers investment exposure to the companies represented by the S&P 500 index. Source of VFINX data is Morningstar.

 

Merriman INSIGHT – This too shall pass

The stock market has delivered a very volatile week to investors, perhaps striking a nerve not felt since 2008. As I write this, the S&P 500 has dropped more than 5% in a week and almost as much today, causing many investors to recall the sickening downturn of what some called “The Great Recession.”

Since 1980, the average intra-year decline for the S&P 500 has been -14.2%, even though annual returns were positive for 27 of those 35 years, or 77% of the time.

082415Chart

The S&P 500 has more than doubled in value from March of 2009 , and we have gone more than 1,400 calendar days without as much as a 10% correction. This is the third longest stretch in over 50 years without such a decline. Since 1928 the S&P 500 has experienced a 10% correction almost once per year with an average recovery of 8 months.

082415TableCorrections of 20% or more for the S&P 500 have historically occurred at the end of market cycles. In the short run the S&P 500 has pulled back 5% an average of four times per year, or about once per quarter. In fact, the S&P 500 has experienced a 5% or greater pullback every year since 1995. Drawdowns of 2%-3% occur far more often, at least monthly on average. As such, pullbacks alone should not be a reason for panic.

In times of increased volatility such as we have experienced, it’s important to revisit these important lessons that are the underpinning of a successful investment strategy. (more…)

Identifying Your Investment Philosophy

investment philosophyI’m never surprised when I meet a tech person who is well informed on particular aspects of the market. As voracious readers, I would expect nothing less. However, that knowledge is often limited to the top-selling finance books focusing on one story or perspective of the stock market, or news articles about why certain technology stocks will rise or fall in the next year.

This is natural – we tend to gravitate toward what is in the news or what we are currently focused on from a business perspective.

What’s amazing to me is when I meet a tech entrepreneur or executive who understands exactly what makes them comfortable or uncomfortable in investing. One individual I talked with had figured out what made her comfortable without fully understanding the technical jargon and the possible ways of investing in the market.

Before I asked a question, she told me she believed in diversification across the entire stock market. She didn’t want to waste time and emotion on trying to time particular industries or company stocks – it felt too much like betting. She told me how much money in dollar terms she was not willing to lose from her portfolio, and that she knew this might affect the likelihood of reaching her goals. She wanted to maximize her investment return while following consistent, scientifically proven methods that made sense to her. She felt this way of investing kept her from needing to look at her portfolio daily and feel concerned when particular areas of the stock market had “bad days.”

Needless to say, I was blown away. Determining your investment philosophy is usually the hardest part. It requires understanding behavioral biases, asking uncomfortable questions and playing to your strengths in what you can tolerate. From this foundation, you can build an approach to your financial future.

Overcoming Behavioral Bias

We all want the upside without the downside. I have seen the internal struggle time and time again – how do you balance investing methodically without reacting to stock market news and the emotional rollercoaster that investing entails?

Investing is about knowing what drives your decisions, and then acting on it. You know what the right thing to do is, but struggle to implement it due to our inherent psychology.

So let’s play a game. First, you are given $10,000.

Now you must make a choice… which of the following would you prefer?

  • A sure gain of $1,000
  • A 50% chance of gaining $2,000, but also 50% chance of gaining nothing

Then, another choice… which of these would you prefer?

  • A sure loss of $1,000
  • A 50% chance of losing $2,000, but also 50% change of losing nothing

Were your answers different? If so, this is loss aversion – the fear of losing money more than obtaining increased value in your investment portfolio.

This belief drives investors to hold on to losing investments and sell winning investments too quickly. Loss aversion is a classic problem of chasing returns. This thinking leads investors to sell stocks near the bottom of a stock market cycle and then not buy the stock back until a substantial increase in price has already occurred.

Here are some other behaviors investors struggle with.

  • Procrastination: Some individuals wish to avoid planning their investing approach altogether. Ben Franklin said it well: “If you fail to plan, you are planning to fail!”
  • Hindsight 20/20: Attempting to time economic shifts and anticipate changes in stock prices may seem obvious when looking back at the event, but it’s very difficult different to accurately predict. Seeing errors in hindsight can makes us overconfident in predicting it “next time,” ahead of the event occurring.
  • Here-and-now reactions: The media has an uncanny ability to focus on particular stories that increase readership and draw the stories out for as long as they can. When looking at economic newscasts, a story is one pin point for an entire outline of what makes the financial markets tick.

Last year’s sound bite? It was all about the S&P 500 rising dramatically. When someone uses the S&P 500 as synonymous with the stock market over the last year or two, this indicates a here-and-now reaction.

How do you feel about the stock market?

This question makes people uncomfortable. I see the shift in their body language and gaze, and suddenly I get the uncomfortable vibes.

“Um, I don’t know,” or “I am in a growth strategy… I think.”

How you are currently invested may not be the best for you. So what are some driving factors in establishing what is best? Here are some things to consider.

What am I willing to lose?

  • How comfortable are you investing in the stock market?
  • How much money (dollar-wise) are you willing to lose from your investment portfolio?
  • The average intra-year S&P 500 stock market drop is 14.7%[1]. How does that make you feel? Surprised, unsettled or unfazed?
  • What are your goals and how much time do you have to save for each goal?
  • What level and kinds of debt do you currently have?
  • How many stock options do you have? What time frame do they vest over?
  • What is your professional plan for the future?
  • What benefits are available to you in your employment agreement? What risks are apparent?
  • What obligations or goals have you set as a family?

What drives your decisions around investing?

  • Do you understand the level of risk inherent in different types of investments (i.e. stocks, bonds, mutual funds, ETFs, private equity, angel investments, etc.)? All investments involve a degree of risk.
  • Do you know what style of investing you prefer?
    • Active investing – managing your investment portfolio by picking particular investments you believe will outperform the financial markets. You will time when to move in and out of each part of your portfolio using different types of analysis to find opportunities.
    • Passive investing – systematically buying into a strategy you will hold for a long time period. You’re not worried about daily, monthly, or annual price movements. You’re looking to capture the persistent and pervasive opportunities the financial market provides overall.
  • What analysis and strategy will you use in maintaining your investment portfolio?
    • Do you believe the financial markets are unpredictable over the short term?
    • Do you believe in diversification?
    • Do you prefer picking stocks?
    • Are you concerned with trading costs and rebalancing your portfolio?

A great book to begin this discussion can be found in my post Where are you on the investment continuum?

Should you do it yourself or hire a financial advisor?

  • Will you manage your own investments?
  • Do you have the time to manage your investments?
  • How will you choose which stock, bonds, mutual funds, etc., to invest in?
  • Are you aware of the fees involved in investing?
  • How will you track the tax implications of investment choices?
  • Will you hire an advisor?
    • How will you find the right advisor for you? Do you trust them?
    • Do you care if they are a fiduciary required by law to do what is in your best interest?
    • Do you understand the difference between hiring a financial advisor at an investment bank or an independent advising firm?
    • Does the financial advisor understand who you are and where you are going?

Your investment philosophy is made up of guiding principles that will govern your future investment decisions. These crucial choices and commitments help you filter through the noise that doesn’t matter and focus on the path to wealth creation, accumulation and maintenance.

Be honest with yourself through the process of investing – it’s easy to reach analysis-paralysis quickly and feel overwhelmed. So whether you’re analytical or laid-back in nature, it’s is easier than you think to misstep and begin judging your future moves based on making up for past mistakes.

That’s where a good financial advisor can step in and help you remove the emotion from investing, while helping you maintain discipline in the markets.

[1] Source: Business Insider, CHART OF THE DAY: Here’s One Chart Every Stock Market Investor Should Pin To The Wall by Steven Perlberg on Dec. 3, 2013. Standard & Poor’s, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2012. The 2013 numbers represent returns as of 9/30/13.