You’re excused for wondering if you should just give up on this whole investment thing. There’s evidence of others doing that or the equivalent. Recently, participants in the options markets purchased twice as many contracts to protect against losses compared to contracts that would benefit from the market going up. In the history of this indicator (~1997), this has never happened before.

We consider this a contrary indicator, sort of like everyone getting on the same side of the boat; it usually doesn’t work out for those folks. In his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” This would suggest the market is due for a bounce.

Still, whether that bounce is a permanent one or just the sort a cat makes when it gets dropped, you may be thinking about sitting on the sidelines for a while.

A common sentiment we hear is some version of I’ll get out and wait until things look better. If this is your line, be forewarned that it will guts of steel since the news will–almost by definition–look worse at lower prices and only look better at higher prices.

That’s a good recipe for this outcome…

What’s more, big market moves tend to happen over very short periods of time. Miss a couple of those, and you may need to delay retirement. The chart below shows that if you missed the five best days of the last 25 years, your $1,000 investment would only have grown to $2,295 instead of the $3,631 you would have had by staying invested.

Our advice remains the same, so long as your investment mix is appropriate for your circumstances, we recommend sitting tight. If you have additional funds, now may be the time to nibble on more investments, since they’re on sale.

The post Enough Already! appeared first on Strategence Capital.

According to the Corporate Finance Institute, behavior finance is: “the study of the influence of psychology on the behavior of investors or financial analysts. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.”

The incredible chart nearby shows an exhaustive, categorized listing of all of the biases that can influence investors. These include things like:

• Availability heuristic
• Hot-hand fallacy
• Expectation bias
• Murphy’s law
• And 171 others

Click here to go to the blog post (not mine) that included this graphic in all its full-size splendor.

Recently, I was cleaning out my office in-box and found some notes I had made about one of these human foibles, called the Possibility Effect. Call it serendipity, call it God, or call me lazy for not cleaning out my in-box until now, but the Possibility Effect is an incredibly timely topic given the current situation.

The Possibility Effect, per my note, is explained below.  See if this sounds like how you and others are feeling about the situation.

When an outcome is possible but not probable, people tend to overestimate its chance of occurring.

List of conditions in which investors are vulnerable to overweighting low probabilities and becoming biased by the possibility effect:

• Vivid or easily imagined results
• Minimal awareness about the event’s likely outcomes
• Minimal investor conditioning or experience with such events
• Event is represented as a relatively novel/unique phenomenon
• Desiring, wanting, or needing the outcome to occur
• Feeling a personal or emotional stake in the outcome
• Feeling excited or fearful about the event happening
• Ambiguous information about the event

So, what’s the big deal? Where’s the problem?

Simple—our minds can run wild and construct scenarios that are possible but have little chance of happening.  From those scenarios, we make decisions that are foolish, and which could later have a huge impact on our futures. For example, I just spoke to a friend who said his dad bailed out of stocks in the financial crisis and now is in bad financial shape because his investments never had a chance to recover.

Most importantly, be aware and then wary of the Possibility Effect and how it might impact your decision making. Use these tools to combat it.

Ask yourself…

• How do I know that’s true?
• What happens if I’m wrong?
• What are the odds that I’m right?
• Have I read anything that disagrees with my thinking?

If you’d like to learn more about behavioral finance and why it’s so important, click here to go to a nice blog post (also not mine) on the subject.

We’ve published other posts about behavioral flaws and cognitive bias.  Now might be a good time to revisit them:

• Hindsight Bias
• The Dunning-Kruger Effect
• Conjunction Fallacy
• Recency Bias
• Confirmation Bias
• Mental Accounting
• Outcome Bias

Securities offered through LPL Financial, Member FINRA/SIPC.

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Imagine you are in a room full of people. Maybe you know them; maybe you don’t. Rate yourself as a driver compared to the rest of them…worse than average? average? better than average? If you’re like most folks, you’ll rate yourself as better than average. The trouble is that most of the people in the group would rate themselves as better than average. If we were all above average, then the average wouldn’t be the average. In short, we can’t all be better than average. Now, imagine you’re in a room full of surgeons. Rate yourself as a surgeon. Unless you’re a surgeon, you’re likely to rate yourself as worse than average.

This is an example of the Dunning-Kruger effect.

In areas where we have some competence, we estimate our skills as higher than they really are because we don’t know what we don’t know. The more competent we are, the more we realize we don’t know. Charles Darwin summed this up well when he said, “ignorance more frequently begets confidence than does knowledge.”

In my opinion, nowhere is this more pronounced than in the field of investments. This is a field where people say ridiculous things like, “I’ll sell when I get my money back,” or “no way; that’s a $20 stock,” or “XYZ stock has been good to me.” Can I just politely say that when you say things like this, you have no idea what you’re talking about?

With that endearing sentence, let me share some things from a recent Barron’s article (“5 Mental Tricks to Make You a Better Investor,” February 1, 2019) that was intended to help investors overcome some of their bad emotional and intellectual wiring, and counteract things like the Dunning-Kruger effect. Here are the five tips.

1. You hold losing investments for too long. Our tendency is to say, like a long-time client of mine says, “I’ll sell when I get my money back,” as if it’s our birthright as investors to always break even. It’s difficult to admit a mistake, and realized losses represent proof of a mistake, but consider the sale proceeds an opportunity to redeploy the funds to a better place.
2. On the other hand, we sell our winners too soon. If a realized loss is a sign of failure, then a realized gain is proof that we really are smart investors. Studies of actual brokerage accounts show that winning stocks that are sold do better than the losing stocks that are held.
3. Getting right at the Dunning-Kruger effect without mentioning it, the third observation was that investors tend to be overconfident. One example of this is investors buying individual stocks, when the vast evidence is that the very best investors do a poor job of performing indexes, many of which are investable via various investment products.
4. Because of our tendency to seek out patterns in the chaos around us, we tend to see patterns where there are none. For example, there is little evidence of athletes’ hot streaks—and certainly not your own investment hot streaks. The suggestion from Barron’s is to “study what you did and didn’t do, keep records, and look at what’s working [and what’s not].”
5. The last suggestion is particularly relevant given the fourth quarter of 2018’s volatility. When stocks are falling and you’re ready to hit the sell button…don’t. Instead, the article suggests, test your own investment markets history by asking yourself things like:

• How often do corrections occur?
• How long do they last?
• What happens if I’m not invested?

You can do this right now, by checking out our Long-term Perspective for Market Movements provided by our friends at Dimensional Fund Advisors and available on our website by clicking here. We’ve found that this presentation may be just what you need to step back from the ledge of bailing out of your investments.

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In the same way that sunshine follows rain, the Wall Street Journal and other news outlets continually do what is described below. I believe it falls into the cognitive bias called Outcome Bias.  Outcome Bias refers to situations in which a decision is evaluated after its outcome is known.

In the November 20, 2018 issue of the newspaper, the Markets section featured the article titled “U.S. Stocks Hit Hard as Tech Worries Deepen.” The article mentioned the declines in Bitcoin, Google, Apple and stocks in the technology sector.

Predictably, the fourth paragraph trotted out the CEO, let’s call him Bob, of a wealth management firm few have probably heard of. In the first half of 2018, the firm “decided that [it] would pare its exposure to risky investments, trimming some of its holdings of high-growth companies that had performed well over the past few years.” This is in spite of the fact that the firm’s investment process emphasizes “risk budgeting and managing for risk, not on short-term portfolio performance.” My emphasis added.

What’s Going on Here?

In my opinion, this example is like assembling a stadium full of coin flippers, and after one of the flippers inevitably flips ten heads in a row, featuring them as an exceptional coin flipper. Had the rout of technology stocks not occurred, we would never have heard of Bob. I’m guessing that over the last several quarters or years, many firms have said things like, “we should get out of/into [insert segment of the market].” In reality, most of them will never be heard from.

Bob and his firm got lucky. They’ll get to frame the article and reference it on their website and say, in promotional material, that Bob has been quoted in the Wall Street Journal. They won the marketing lotto.

But please don’t be confused. Bob and his firm do not have a consistent edge. They were just lucky.  They flipped heads ten times in a row, so to speak. Do it often enough, and you likely will, too.

Source: Wall Street Journal, November 19, 2018

Learn more about cognitive biases:

Hindsight Bias

Conjunction Fallacy

Recency Bias

Confirmation Bias

Mental Accounting

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This is the fifth cognitive bias covered on our blog. I would guess that nearly every financial advisor has seen this bias played out in his or her clients, and you almost certainly do some mental accounting, yourself—and probably for good reason, but mental accounting can be problematic.

Here’s an example of mental accounting from the book, Misbehaving, by Richard Thaler.

• Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater, you discover that you have lost the ticket. Would you pay $10 for another ticket?
• Now imagine that you have decided to see a play that costs $10 per ticket. As you enter the theater, you discover you have lost a $10 bill. Would you still pay $10 for a ticket?

When he conducted this study, 46% of respondents to the first question said yes. To the second question, 88% said yes, but the economics were the same in both cases: the subject was out $10.

Budgets, which we highly recommend to clients, and use ourselves, are another form of mental accounting. The $20 bill in your Utilities envelope can just as easily be spent on dinner out or put toward groceries, but we create budgets as spending guardrails.

For an example of mental accounting that can get one in trouble, consider the cost basis of an investment. Aside from taxes, what does one’s cost basis have to do with sound investing? A stock selling for five times the $2,000 one paid for it is no more or less valuable than the stock selling for one-fifth of the $50,000 one paid for it. In both cases, the stock is worth $10,000. Yet, absent tax considerations, we are far more loathe to sell the stock in the second case.

So, what are some practical steps investors can take to defend against this potentially-ruinous cognitive foible?

1. When looking at a statement, cover up the cost column. Some online account views allow columns to be hidden or de-selected; do so.
2. Consider using stop-loss orders, which execute once a certain price is reached. These are not perfect, as they can execute far below the stop-loss price.
3. Think about the value as capital and make sure it’s deployed in the most-likely-to-be-rewarding venture…“okay, I have $10,000. Is this where I would invest it if I was starting afresh?”

To read prior posts about behavioral flaws:

• Confirmation Bias
• Recency Bias
• Conjunction Fallacy
• Hindsight Bias

The post Mental Accounting appeared first on Strategence Capital.

This might be one of the easier behavioral shortcomings to detect.

In short, confirmation bias refers to the tendency to seek out things that confirm our beliefs. As Daniel Kahneman puts it in Thinking, Fast and Slow, “people seek data that are likely to be compatible with the beliefs they currently hold.” It’s not too difficult to see examples of this bias. For example, if you think President-elect Trump is an idiot, you’re likely to avoid news stories to the contrary. In fact, along those lines, the site youarenotsosmart.com—which has a superb podcast, as well—cites a 2008 study:

During the 2008 U.S. presidential election, Valdis Krebs at orgnet.com analyzed purchasing trends on Amazon. People who already supported Obama were the same people buying books which painted him in a positive light. People who already disliked Obama were the ones buying books painting him in a negative light. Just like with pundits, people weren’t buying books for the information, they were buying them for the confirmation.

One sees confirmation bias in our business all the time. Consider the case of Harry Dent, who is the author of numerous books, including the modestly-named titles, The Great Boom Ahead (1994) and The Great Depression Ahead (2009.) He has produced subsequent titles, along the lines of the latter. He recently admitted to mistiming the market’s correction, which he claims is still coming, but in this business early looks a lot like wrong. Regardless, one wonders how much reading he did of things that were contrary to his beliefs over the last seven years.

Part of our company’s name comes from “Intellectual Integrity” (the rest coming from “diligence” and “strategy”), because of the importance we place on seeking out non-confirming information.

If you want to learn more, check out these related articles:

• A Simple Strategy for Shaking Confirmation Bias
• Confirmation Bias and the Perma Whatevers
• Confirmation Bias Quotient

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This is the third cognitive bias covered on our blog so far, and this is one we see all the time as financial advisors. In short, recency bias is the tendency to think that what has happened recently is what will happen in the future. We assume that an investment that has gone up or down will likely continue to go up or down, that a team that has done well will continue to do well, and so on. In my opinion, this is one of the more potentially damaging biases. It can lead us to sell a security that has declined because we think it will go to zero, and it can lead us to buy a security because we think it’s going way up.

How do we deal with Recency Bias?

Here are three steps to combat this bias.

1. Know that it exists
2. Recognize that there are likely multiple outcomes
3. Try to objectively access the odds of each outcome.

The third step is especially important, as it leads to another bias: the confirmation bias. We will address this cognitive bias in an upcoming post.

Related articles of interest:

• Tomorrow’s Market Probably Won’t Look Anything Like Today
• Is Recency Bias Influencing Your Investing Decisions?
• Defining Recency Bias

Learn about other cognitive biases:

• Hindsight Bias
• Conjunction Fallacy

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One of the foundations of classical economics is that all participants in it are rational, or as put in an earlier era, all are rational men, homo economicus. One doesn’t have to consider for long that we are not absolutely rational. For just one example, we are risk averse; if one loses $100, one feels more pain than one feels pleasure upon finding $100.  I believe that in the matter of investments and financial markets, it is especially important that we are not subject to the whims of our emotions, which tend to overwhelm our rationality.

The cognitive bias related to this is the conjunction fallacy.

In his book, Thinking, Fast and Slow, Nobel-prize winning author, Daniel Kahneman (biography here), explores what he calls the “Conjunction Fallacy,” and we shall consider it here. According to James Yearsley at Vanderbilt University, “the ‘Conjunction Fallacy’ is a fallacy or error in decision making where people judge that a conjunction of two possible events is more likely than one or both.”  In the book’s section on Heuristics and Biases he presents the conjunction fallacy in the form of the Linda experiment, which he says is “the best known and most controversial” of his experiments.” Linda was described in the early ‘80s as follows:

Linda is thirty-one years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.

Students were then presented with scenarios and asked to rank the scenarios by probability. Two of the scenarios were these:

1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.

Which do you think is more probable? In one version of the experiment, administered to the “doctoral students in the decision-science program of the Stanford Graduate School of Business,” fully 85% of the respondents answered incorrectly.

It is more probable that Linda is a bank teller than that she is a feminist bank teller. Think about it.  The second category is a subset of the first, as shown in both of the diagrams below.  Any time we add conditions, such as Linda owns two or more cats, the likelihood goes down.

Read our earlier post about the behavioral flaw of hindsight bias.

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Hindsight bias is just one of the many psychological biases that investors are subject to. It’s the tendency to look back after an event has occurred and say, “I knew that was going to happen.” For example, after the tech bubble burst in 2001, there were many who said they had “predicted” it. Similarly, after the financial crisis of 2007/2008, folks came out of the woodwork to say they knew it was going to happen. Indeed, there are always some astute folks who make a big call and get it right. Google “Elaine Garzarelli” and you’ll find that she did issue a warning about 1987’s Black Monday. What we don’t have, however, is a humility bias. If we did, we would attribute a lot more to luck.

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