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My Foresight is 20/20...or Is It?

November 8, 2019

 
Rob Brown
Clinton Lynch

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Imagine you wake up tomorrow, pour your morning brew, flip open your iPad, and start reading the Wall Street Journal. Suddenly, by some strange twist of fate, you realize you are reading the stock market results one week into the future, rather than to yesterday’s closing prices! This has always been a dream of many financial professionals, as well as individual investors. In actuality, no one has consistently predicted short-term stock market performance. In fact, it has been said that, when it comes to the market, there are two types of investors; those who don’t know what the stock market will do and those who don’t know that THEY DON’T KNOW what the stock market will do! Undoubtedly, as it relates to short-term market movements, the Yogism “it is dangerous to make forecasts, especially about the future,” holds a lot of truth. Conversely, if you said the market goes up, in the long run, the past 100 years of data would support your claim. The average return of the S&P 500 has been roughly 10% annually from 1926-2018. So, if we know that the market has produced positive results over time, despite the short-term unpredictability of outcome, why do many investors seem to still lose money and underperform the market?

Dalbar Inc. has been the industry leader in studying investor behavior for the past few decades and has come up with some surprising conclusions. Over a cited period of 20 years, the average individual investor underperformed the stock market by close to 4% per year. Why the huge discrepancy? Well, there are a number of factors, but much of it is believed to be tied to human error. Simply put, investors are prone to making poor investment decisions and they seem to repeat their mistakes. The blunders are so far reaching, that it has spawned an academic discipline known as behavioral finance. This recently studied phenomenon seeks to examine why people make some of the financial choices they do, and what impact this has on both the stock market and personal investment returns. The following are some commonly-studied behavioral finance biases: 

  1. Loss Aversion - Studies show investors are two-and-a-half times more concerned about avoiding investment losses than they are about growing their investment gains. It seems that investors agree with Will Rogers, who stated 100 years ago,“I am more concerned with the return of my money than the return on my money.” So, practically speaking, loss aversion leads investors to either accept too little risk by remaining underinvested or to sell when their investments temporarily lose value. Both situations lead to underperformance over time. Stock markets are considered as irrational as the humans that drive them. In fact, some have described the full investment process as a cycle of My Foresight is 20/20… or Is It? ROB BROWN AND CLINTON LYNCH going from optimism, thrill, euphoria, anxiety, denial, fear, desperation, panic, capitulation, despondency, opportunity, hope, relief, and finally, back to optimism.
  2. Endowment Bias – Individuals tend to place a higher value on objects that they own than they would otherwise place on that same asset. A great example is real estate; most homeowners think their house is worth more, immediately after they have moved into the property. However, in reality the likely change is the emotional attachment. The same holds true with stocks. Once investors purchase a stock, they typically value the stock more, in part to support their ego. To protect oneself against this bias, a good question to ask is, If I didn’t own this stock or real estate investment today, would I buy it at the current market price? This can be a simple way to try to remove endowment bias from the calculation.
  3. Anchoring Bias - Anchoring bias occurs when we rely too heavily on the first information we receive in making a decision. For example, an investor might purchase a stock because it looks like a bargain at $100, compared to their neighbor paying $150 per share three months ago. The focus could dangerously be on the discount in price versus the actual business value. Anchoring bias transcends investment decisions and can certainly tip the scales out of your favor.
  4. Confirmation bias - This bias suggests we tend to seek out information that confirms our pre-existing beliefs. One scenario might be if an investor who loves Apple products tends to consciously seek out financial reports that support their sentiment of Apple being the most revolutionary company in history, with an ever-increasing stock price. Another person who feels that a market crash is imminent might look for validation with news pundits and talking financial heads, known for their impassioned pessimism. Confirmation bias infects many investors, not to mention political viewpoints.

So, how do we protect ourselves from these behavioral biases? The first step is selfawareness and acceptance of our bias and blind spots. If we cannot accept that we all have selflimiting tendencies, we will be prone to making more mistakes. The next step is to develop a plan to take as much of the emotion out of investment decisions as possible. One example of this would be taking a rules-based investment approach, such as dollar-cost-averaging over a set period, regardless of where the market is trading. A further example would be setting up a sell-price target for a stock you own. Another tactic would be to turn to a professional advisor. Good advisors should act as your strongest financial advocates and as a non-partisan sounding board. They should be the voice of reason and keep you on track, when emotions run high.