Looking Inward

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August 2015 was an inauspicious month for equity markets around the world. Although the sell-off decelerated as the month drew to a close, our own S&P 500 dropped a little more than 6%, Japan’s Nikkei was down 8.2%, Germany’s DAX 9.3%, China’s Shanghai and Hong Kong’s Hang Seng posted losses of over 12% each, and Great Britain’s FTSE lost 6.7%.

The media, constantly in need of a current story, has ascribed the cause of such decline as 1) China’s issues that have surfaced in both its economy and markets marked by the devaluation of its currency; 2) the probability that the Federal Reserve may finally raise interest rates; 3) the precarious nature of the European Union as evidenced by its interactions with Greece; and 4) the inability of the emerging markets to save the world with their demand for commodities. Add computerized, high-frequency trading to the news-making events and you have a recipe for nerve-wracking volatility. But the real question remains. Is this simply normal market volatility or is it something more? Let’s dig a little deeper.

You have heard me extol the primacy of growth many times in previous columns. It is fascinating that so few journalists speak about the stagnant nature of the world’s economies, opting instead to speculate ad nauseum about the Fed’s next move. The recent GDP announcement of 3.9% U.S. growth in Q2 2015 was celebrated briefly. It needs to be, and in fact could be, well over 5% with the right policies in place to incentivize growth and to reduce corruption. As a nation, we have placed too heavy an emphasis on the Federal Reserve interest rate policy and held off on laying commensurate responsibility at the feet of policymakers. We appear to all have become addicted to the short term fix rather than focusing on long term growth solutions. To assess your own financial future, the central question today is whether you believe that all this is likely to change anytime soon. I do not believe it will. If you haven’t already, it’s time to take seriously your family’s financial future. A good place to start is looking inward.

This summer I had the good fortune to meet Dr. Thomas Howard, author of Behavioral Portfolio Management: How successful investors master their emotions and build superior portfolios. The book explores the role emotions play in every aspect of financial markets – from how huge sophisticated markets price securities, to the conventional wisdom doled out by investment professionals, to the investment decisions made by individuals and professionals. With the aforementioned losses of August, now is a good time to be thinking about your own reactions to the market. Dr. Howard suggests that staying disciplined in an emotionally-charged, 24-hour news cycle world is a challenge. He presents Behavioral Portfolio Management (BPM) as a superior way to make investment decisions.

Emotions and heuristics, according to Dr. Howard, act as brakes on our decision process, preventing us from making good decisions. Here are the most important cognitive errors made by investors according to Howard.

Myopic loss aversion (MLA) is so prevalent because we humans experience far greater pain from losing than joy from gaining. In fact, there is evidence that the pain of loss is about twice as great as the joy from a comparable sized gain. This leads to short term evaluation of performance, even for long term goals which often results in premature abandonment of an investment strategy. I call this the tyranny of short time periods.

Closely related to MLA is the cognitive error known as fallacy of composition. Many investors believe that in order to do well over the long-run, they must do well in each and every period. Any investment, other than cash, is likely to have periods of negative return.

Herding or social validation is another cognitive error. None of us want to be part of a herd; however, we are hard-wired to seek social validation where we can find it. The lesson of our past is that sticking out from the crowd by doing something different is dangerous. It is only natural to carry this into investment decisions. This is demonstrated by buying what our peers are buying or by buying larger, rather than smaller funds.

Interestingly, Howard places stories on the list of cognitive errors of investing. Studies show that we would rather hear stories about complex economic facts than sift through economic statistics. Moreover, we tend to judge the story’s validity by the reputation of the storyteller and whether an explanation is logical to us. He also points out that the more detailed the story, the greater the validity attached (when in fact, more detail increases the chances the story will be wrong).

Ever hear the words “past performance is no indication of future performance?” Of course you have. They are contained in every prospectus, performance report, and every advertisement of investment products. But what does everyone do to estimate future performance? They use past performance data. Numerous academic studies confirm this and some even go on to suggest that the exact opposite is true, with poor past performance predicting superior future performance. This is an example of representativeness. Surprisingly, Howard contends that chief among the representativeness error is to infer that the good or bad qualities of a company, however we define those, are representative of the investment qualities of the stock.

There are other biases that will be addressed in a future article, but for now ponder whether you are applying any of these in the current market situation. We will also discuss how to release your emotional brakes and move on to more rational investment decision making. If you would like to discuss this, or any other matter relating to your personal finances, give us a call or send and email. It is always good to hear from readers.

Scott Neal is president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Comments and questions are welcome at 800-344-9098 or scott@dsneal.com.