Neurotic Investment Behaviors that Trip Us Up (1 of 3-part series)

In his book Global Asset Allocation, Meb Faber provides an obvious yet elegant insight that few investors take the time to contemplate: "Unfortunately for investors, there are only two states for your portfolio – all-time highs and drawdowns." At every point in time, your portfolio is either at new highs, or it is worth less than its peak.

Meb continues:

"The 60/40 allocation only spends about 22% of the time at new highs, and the other 78% in some degree of drawdown. Drawdowns are physically painful, and the behavioral research demonstrates that people hate losing money much more than the joy of similar gains. To be a good (read: patient) investor you need to be able to sit through the dry spells."

Given that reality, it is therefore worthwhile to take a few minutes to understand some of the basics of behavioralist economics. Primarily, to better understand and moderate our own behavior. But additionally, when you consider that "The Market" is comprised of the collective buy and sell decisions of a large number of actors each influenced by their own biases, the impact of these behaviors on price movements - both rational and irrational - grows exponential.

I don't claim rigorous course work or expertise here, but at their core these ideas are pretty common-sensical. In my view, the field should be broken down into two key segments: the innate biases we exhibit, and the contextual heuristics we employ in an effort to rationalize those feelings.

Innate Biases:

Loss Aversion:

This is the "drawdown pain" in Meb's quote above, and the basic element behind many of these behaviors. Physiologically, our brains process loss as they would process emotion, whereas gains are processed as a surge more akin to adrenaline. The result is that loss creates long-term feelings of regret and despair. We don't like those feelings.

Survival Bias:

The fight-or-flight extension of loss aversion. A feeling that we must act in order to eliminate a threat or alleviate discomfort - including the emotional discomfort of loss.

Optimism Bias:

This can be thought of as hubris or overconfidence. Basically, we overstate our ability to make optimal decisions, and often believe that we can exert an unfounded level of control over a situation. It's what drives 80% of the population to believe they are good drivers. We like to oversell ourselves.

Story Bias:

We're simply not that smart. We would much rather hear a compelling story than a well-researched analysis. Moreover, we don't like others to know that we aren't that smart - embarrassment is an incredibly powerful emotion. Oh, and we also get bored very quickly - and that is only getting worse with technology.

Herding:

Greed, or fear of missing out (FOMO). We don't like seeing our neighbors get rich when we are not - in fact, that is considered a loss on a relative basis, which we know is processed at a deep emotional level. This is what allows Ponzi schemes to become so wildly successful.

Anchoring:

Somewhat the converse of herding - a distaste for buying or selling an asset at a worse price than its recent print. My friend Keith Weldon refers to that behavior as "looking down instead of looking up". Warren Buffet said "That thumb-sucking, the reluctance to pay a little more, cost us a lot."

Impatience:

The need to "do something", currently embodied by the concept of "TINA" - There Is No Alternative - used today to justify the extended valuations of global capital markets. Sitting on the sidelines is hard.

As flawed human investors, we are significantly imprinted by these innate behavioral conditions. The real problem comes when we embark upon an investment plan that attempts to align our biased inputs with impartial markets. This gives rise to a whole other set of heuristics we employ to make that "best fit" possible.

Contextual Heuristics:

Extrapolation Bias:

The building block of context errors. Predictions are made using the closest match to past patterns, regardless of the probability of that pattern asserting itself. Nassim Taleb popularized the concept of a black swan event, what statisticians for decades have called a fat-tail event. An extrapolation bias would have you believe these are common occurrences.

Recency Bias:

An evolution of the extrapolation bias, this leap overweights the probability of an occurrence by its timing juxtaposition to a recent event. The recency bias would make you more likely to believe we are about to experience a black swan event because the painful memory of the last one is fresh in our minds.

Availability Bias:

An extension of the recency bias. this mental shortcut gives disproportional weight to circumstances that are easy for us to recall. Often feeding into this is a media bias - we are conditioned by what we hear repeatedly from news outlets. And of course, sensationalism sells. The media talks about black swan events, so we ponder whether one is imminent.

Confirmation Bias:

Once we have hypothesized a viewpoint, regardless of it's probabilistic likelihood, we search for sources not to diligently test our theory but rather to confirm it. Of course, that is not hard to do with an internet browser at your disposal.

Of course, some out there do genuinely skew towards the more rational and analytic end of the spectrum. But even this minority suffers from yet another painful condition: analysis paralysis - the burden of the perfectionist, which is still rooted in the same innate biases enumerated above.

So - great? We're all a mass of neurotic investment mistakes waiting to happen? What do we do about it?

The answer lays in developing a disciplined investment approach - which we will elaborate upon in our next post.

DD