Following the herd may only hurt; trust your plan, instead
I have always found Behavioral Finance interesting as it tries to explain the “why” behind investors decisions. When I first studied finance in college very little was discussed about why investors did things. We were taught the efficient market hypothesis. It assumed that all information was readily available, investors are rational and because of this stock prices were on a random walk.
In the twenty years of working with investors, the one thing that is apparent… investors are not rational. We do things all the time that are not in our best interest. We are emotional creatures, often times our emotions can be at the wheel and we can make some big mistakes. My purpose in writing this, is that I might be able to help you avoid an early first-quarter mistake that I see investors make on an annual basis.
Before we discuss what this mistake is, let’s talk a little behavioral finance as it relates to Representativeness Heuristic and Availability Heuristic so we can understand how our minds might work in hopes we might not fall victim and draw the wrong conclusions. A “heuristic” is a mental shortcut to speed up decision making.
“Representativeness,” is an event that represents its parent population or a group of data points. Consider the following example.
Tom loves classical music. He likes to head into the city, his first stop is to his favorite café to get his favorite mocha; he then heads over to visit the art gallery. He also enjoys going to the symphony, because he learned to play the violin at a very young age. What is Tom more likely to be, a professional violinist or a farmer? Based on the following description most people would think he is a professional violinist. He fits the stereotype of violinist rather than a farmer. In reality the probability of Tom being a farmer is greater than that of a violinist, because farmers make up a larger population than violinists. The data points in the description help us to quickly conclude what is being represented. When I tried this example out on my wife she said, “They don’t have farmers in New York City”. She obviously represents cafés and art galleries to New York City.
“Availability,” is the ease of a particular idea to be brought to our memory. When people estimate the probability of an event based on their recall of events they are using availability heuristics. Sometimes people will underweight something that is common and frequent because it is hard to recall a mundane event. On the other hand, dramatic less frequent events are easily brought to memory and might be overestimated in our decision. The Great Recession would be such an event where investors overestimate the frequency of the event occurring soon. Do you remember how many were calling for a double dip recession?
An example of these two heuristics takes me back to when I first got into the finance business. The “dot-com” boom was in full force. Almost all companies and households were trying to get online. Microsoft Windows 95 included the first version of Internet Explorer. This was most people’s first experience with the web. It was an exciting time as the tech revolution was ramping up. Investors shrugged off warnings of “irrational exuberance” put out by then Fed Chairman Alan Greenspan. They were encouraged by some early success. The “availability” of recent memories made them underestimate the possibility of the bubble bursting and they could only see the trend continuing. Investors “represented” truly random sequences into short-term-patterns. They tried to find patterns or trends for which they could justify their current track. They started to draw conclusions too quickly about overvalued stock prices and felt that the trend will continue. Soon we saw a “herd effect”; all these investors can’t possibly be wrong, right? “Now you know the rest of the story”
I worked on a trading desk, self-directed traders called in to discuss their trades. In January investors would receive their annual reports on their respective holdings. These reports showed how the positions performed over the last 1, 3, 5 and 10-year period. The vast majority of the conversations and trades were identical. They were selling investments that underperformed and buying investments that did better over the past 1-year or 3-year period. They are representing these successful returns as future success. This is a huge mistake! Are the returns a microcosm of like investments that have propelled their success? Could the short-term market be favoring a sector and this investment is heavy in that sector? Will this trade make me more diversified or more concentrated? Without asking further questions these investors could possibly be selling an undervalued investment and buying an overvalued investment. You might recall your first unsolicited lesson relating to investing, “buy low, sell high”. They need further evidence that what they are doing is rational. They might recall some recent headline news on the market and how it is growing, the availability of that memory causes them to execute the trades without further questions. I witnessed this first hand during the dot-com runup. Investors were using short-term trends selling off value stocks and buying growth stocks getting less diversified.
It’s important that you maintain a disciplined and diversified approach when making investment decisions. A disciplined approach suggests that you have already put together a plan that takes into consideration your short-term and long-term needs and you have assessed the risk that you’re willing to take. When you are evaluating performance make sure that you’re comparing apples-to-apples. Don’t compare your large cap holding to a small cap holding. Don’t use short-term trends or data points to draw a conclusion of your future investments. Don’t use these mental shortcuts to make investment decisions, instead ask questions like the ones above to make sure you are staying disciplined. Don’t try to predict strengths or weakness in the market, this is market timing. I have not met anyone who can, with a high degree of success predict market strengths and weaknesses and be able to efficiently execute the appropriate trades to take advantage of it. I have, however, met many who have the “illusion of control,” and believe they can influence the outcome of purely random events which make up the market. In many cases they have ended very bad. Market timing is a fool’s game!