Investor Psychology

For the most part, people are risk averse. We prefer not to take on any additional risk unless there’s an increase in expected return.

On occasion, however, we’re not risk averse. We’re risk seeking. When we go to a casino or play the lottery, we’re taking on risk despite the fact that our bets have a negative expected return.

Why? Because in some contexts, risk is fun. It’s entertainment.

Picking Stocks for Fun

Many investors like to pick stocks for fun. For them, attempting to outsmart (and outperform) the market is an enjoyable intellectual challenge. (And for the record, I see nothing wrong with that, as long as they’re aware that the value is in the entertainment rather than in the likelihood of success.)

But what does this have to do with those of us who are buy and hold investors, who have no interest in picking stocks? In short, we may want to attempt to avoid investments that carry a high entertainment value.

The most obvious examples of such investments are penny stocks and IPOs. Because so many people use them like lottery tickets, their long-term historical returns (as a group) are rather low, despite their high risk.

Further, some experts–William Bernstein in The Investor’s Manifesto, for instance–argue that a part of the reason for value stocks having slightly higher historical long-term returns than growth stocks is that growth stocks (especially small-cap ones) carry a higher entertainment value than value stocks.

In other words, it’s fun to try to pick the next Microsoft or the next Google, so many people try to do exactly that. And in the process, they drive prices of small-cap growth stocks upward and returns downward.

The natural response, of course, is to actively seek to make your stock portfolio as boring and unglamorous as possible. The less popularity or entertainment value an investment has, the better.

May 24, 2010 7 comments

“I created my system back in 2001 and have been using it since. It works. It’s not luck.”

This claim came from an investor explaining his method for picking market-beating mutual funds.

9 years is a long time in a person’s life. Can you think of something you’ve been doing for the last 9 years? Whatever it is, it’s probably an integral part of your identity by now.

In this person’s mind, his market-beating ability is a part of his identity. Tell him there’s a good chance that he’s just gotten lucky, and he’ll think you’re full of crap.

But it’s true. 9 years isn’t a large enough sample size to tell us with confidence whether this investor’s results were due to skill or luck.

Anecdotal Evidence

I particularly like this quote from John Cochrane, professor of Finance at the University of Chicago:

“Modern medicine doesn’t ask old people for the secrets of their health. It does double-blind clinical trials. And to that we owe a lot of our health. Modern empirical finance doesn’t ask Warren Buffett to share his pearls of investment wisdom.” (from this video)

We have a natural tendency to assign too much significance to anecdotal evidence, especially when that evidence is our own life experience. Yet anecdotal evidence is worth almost nothing. Even if it’s yours.

The fact that somebody has successfully beaten the market by picking stocks, picking funds, or jumping in and out of the market at the right times doesn’t mean a thing…

• unless we can combine that with other information about other investors who are doing something similar and (reliably) getting similar results, or
• unless we can see that the degree to which (and reliability with which) the investor is outperforming the market is sufficient to show that it’s not due to randomness.

One investor (or one fund) over one decade just doesn’t cut it.

January 13, 2010 18 comments

Personal finance is one of those fields in which our human brains seem tailor-made to fail.

• We’re overconfident in our abilities,
• We try to make everything fun/exciting, and
• We’re hardwired to run at the first sign of trouble.

Often, the best approach is to recognize our psychological shortcomings and make concessions to deal with them. For example, if Investment Approach A is mathematically superior to Investment Approach B, but we don’t have the psychological traits necessary to carry out A successfully, it might be better to go with B.

A few examples:

Asset Location

Mathematically, it makes more sense to put all of your fixed income investments in your tax sheltered accounts before putting any equity investments in them.

Yet it’s much easier to simply use the same asset allocation for each account. (For example, if you intend to have a 60/40 stock/bond allocation in your entire portfolio, use a 60/40 allocation in your 401k, in your IRA, and in your taxable accounts.)

Also, using the same allocation in each account eliminates a situation in which one account is extremely volatile (and therefore worry-inducing) because it has all of your stock investments in it. One single mistake–like bailing out of the market after a downturn–would eliminate any gains derived from tax-sheltering your bonds instead of stocks.

Debt Snowball

Mathematically, there’s no question that the best approach is to pay off debt in order of interest rate, regardless of balance. So, typically, that means consumer debt, followed by mortgage debt, followed by subsidized college loan debt.

Yet Dave Ramsey’s “Debt Snowball” method of paying off debt encourages people to pay off debts in order of size (smallest first), and it’s possibly the most successful debt repayment method ever devised. It takes advantage of the fact that frequent victories early in the process tend to motivate people to keep at it.

Invest First, Or Pay Off Debt?

Mathematically, you should invest prior to paying off debt anytime you expect to earn a rate of return that’s greater than the interest rate of the debt you’d be paying off.

Yet, as Matt reminded us yesterday, many people derive a real psychological benefit to being completely debt free. To value that mental benefit at zero seems to be a mistake.

How do you resolve it?

Do you find yourself running into these same math vs. psychology conflicts (or others that I didn’t mention)? If so, how do you attempt to resolve them?

September 3, 2009 5 comments

I know many frugally minded people like to use something called the “30-Day Rule” to help curb their spending. Here’s how Leo from ZenHabits once explained it:

Make a new rule: you can’t buy anything (except necessities) until a 30-day waiting period has passed. Put a 30-day list on your refrigerator, and when you have the urge to buy something, put it on the list with today’s date. After a month has passed, you can buy the item. Many times the urge will have passed and you can just cross the item off the list.

The reasoning is that when we see a shiny new toy, we want it. Our emotions kick in and attempt to overtake our more sensible lines of thinking. If we delay action, it gives the emotion a chance to subside somewhat, thereby allowing us to think clearly about whether making the purchase really does fit in well with our goals.

Let’s apply it to investing.

How about this: Every time you’re tempted to adjust your portfolio in some way, don’t. [Noteworthy exception: Regularly scheduled rebalancing.] Instead, write down your idea, your reasoning behind it, and the date. 30 days later, if the reasoning still makes sense, then (perhaps) give it a go.

For example…

• Many investors are tempted to respond emotionally to big market swings.
• Other investors are frequently tempted to “tinker” with their portfolios.

Give it 30 days. If it truly made sense in the first place, it should still make sense a month later. On the other hand, if the idea doesn’t seem so wise when considered again 30 days later, it’s likely that your emotions were getting the better of you originally (even if you were unaware of it).

Quick note: The rule only works when we’re talking about portfolios with a lengthy investing time frame. (An asset allocation that makes sense for 15 years is probably also a good one for 14 years and 11 months, but an investment that is ideal for a 3 month time frame may not be fitting for a 2 month time frame.)

It’s difficult–if not impossible–to eliminate the emotional urges to take unwise actions (whether buying some unnecessary luxury or pulling out of the market after a drop), but what we can do is put systems in place to help overcome those emotions.

July 7, 2009 4 comments

Ever since I first read about it, I’ve found the Monty Hall problem to be absolutely fascinating. It’s a math question that almost everybody gets wrong–even very smart people who have careers in math. Here’s the riddle:

Suppose you’re on a game show and you’re given the choice of three doors. Behind one door is a car; behind the others, goats.

The rules of the game show are as follows: After you have chosen a door,the door remains closed for the time being. The game show host, who knows what is behind the doors, now has to open one of the two remaining doors, and the door he opens must have a goat behind it. If both remaining doors have goats behind them, he chooses one randomly.

After the host opens a door with a goat, he will ask you to decide whether you want to stay with your first choice or to switch to the last remaining door. Imagine that you chose Door 1 and the host opens Door 3, which has a goat. He then asks you “Do you want to switch to Door Number 2?” Is it to your advantage to change your choice?

When they read the question, most people (myself included) answer that changing doors wouldn’t affect the chances of winning. And most people are wrong. If you switch doors, your chances of winning the car increase from 33% to 66%. It seems like a simple question, though, doesn’t it?

Fooled by common sense

In a similar vein, Nassim Nicholas Taleb, in his book Fooled by Randomness asks:

What is the greatest factor in determining how many fund managers outperform the market in a given year?

Here’s what came to mind for me as possible answers:

• Average expense ratio among mutual funds
• How well the market did that year (with the dodgy assumption that actively managed funds would outperform in down years due to their significant cash holdings)

The real answer? The total number of fund managers attempting to outperform the market is the biggest factor in determining how many fund managers do outperform the market.

Oh yeah. Duh. It’s so obvious, and yet I hadn’t thought of it.

What’s the lesson here?

It seems to me that the takeaway is that, when it comes to investing, the most obvious answer isn’t always the correct one. For example, common sense tells us that:

• A growing company should be a growing stock. (Wrong.)
• Professional management should beat no management. (Wrong.)
• A fund manager who has outperformed the market for the last 7 years in a row must be good at what he does. (Wrong.)

In the world of investing, terrible practices can be supported with common-sense-sounding arguments.

June 1, 2009 8 comments