CityScope
April 3,, 2003
The bursting of the stock market bubble since March of 2000 has left many investors, professionals and laymen alike, conjecturing what went wrong. How did the market climb to such dizzying heights and absurd valuations? How could so many investors, perhaps most importantly professional investors, abandon the rational investment disciplines that have been developed and taught to all since the “roaring 20’s” went bust? And perhaps of greater importance, how can we learn not to repeat the same mistakes in the future?
Clearly flawed analyses, excessive ambition and corporate corruption are partly responsible for the excessive valuations during the late 1990’s. However, had investors adhered to unbiased and rational decision making the bubble would never have inflated so large. Instead of rehashing the corporate abuses that are now headline news, I am going to delve into some of the natural cognitive flaws that often lay waste to sound investment strategies. Hopefully, by identifying the hidden flaws in the way that our brain works, we can be on guard against some common pitfalls that can lead to disastrous investment results.
Almost
all investment and business theories are rooted upon the premise that
individuals act rationally. And while we all know firsthand that we are not
constantly rational, we also realize that theories based on the assumption that
individuals act irrationally would be ridiculous. So we assume that individuals
will process information in a rational manner. After all, the complexity and
computational power of our brain makes even the most sophisticated super
computer look rudimentary.
Astute investors, however, will want to modify the rational theories of economics and investing to incorporate the idiosyncrasies of human nature. Social scientists and behavioral economists in particular, have long identified various inadequacies in the brain’s ability to process information. Whether these mental mishaps are genetically imbedded or learned remains open to debate; but these mishaps are fairly common and are likely derived from short-cuts the brain has developed to process life’s challenges. For example, if someone yells “FIRE” and everyone in the room stampedes for the exits, then the brain assumes that their must be a fire! Even as these short-cuts prove beneficial in most circumstances, they often can be the cause for poor decision making in the business and investment world. Four insights, that I have adapted from behavioral economics, follow which may resonate with readers as plausible culprits for poor investment decisions.
The mass never comes up to the standard of its best member, but on the contrary degrades itself to a level with the lowest.
Henry David Thoreau
From Nazi Germany to mob lynchings to the recent looting of Baghdad, history is replete with tales of individuals subjugating their rights, morals and senses to “group thought”. For whatever reason, we humans feel a strong pressure to conform to the behavior and opinions of others. While conformity may benefit us and society in certain ways, it often robs the mind of analytical thought: and when our pocket book is involved, it often just robs us.
The recent bull and bear markets serve as an excellent example of the herd mentality. While almost everyone is aware that the S&P 500 index of stocks declined dramatically between January 2000 and October 2002, not everyone is aware of the decline’s composition. Of the index’s 37 percent decline, 25 percentage points can be credited to information technology and telecom companies and 9 percent to the mega-capitalization stocks. Only 3 percentage points of the decline can be attributed to the other 380 companies comprising the index.[1] Given the fact that nearly 80 percent of the companies in the index saw little decline during this “bear” market, chances are that if your portfolio was down significantly, you (or your investment managers) were running with the herd. As an aside, one of the many reasons that I chose to make Chattanooga my home was to help insulate me from the herd mentality of Wall Street.
Realizing that the vast majority of stocks fared well leads to the $64,000 question: why did so many professional mutual funds and investment advisors perform as poorly as the S&P 500? Perhaps Warren Buffett said it best, when indicting the herd instinct in 1984 he wrote, “Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.”
The world hates change, yet it is the only thing that has brought progress.
Charles F. Kettering
An interesting psychological study illustrates our reluctance to change when dealing with financial issues[2]. Each student in a class was given a large hypothetical inheritance. Half of the students received their “inheritance” in the form of low-risk government bonds; the other half received high-risk stocks. Common sense would argue that students would assess their risk tolerances and investment horizons and then reallocate the inheritance appropriately. Instead, each group simplistically chose to keep the investments inherited. What does this tell us? Our brains basically prefer the status-quo to change, even if the change will almost assuredly lead to better results.
For example, I often hear investors say, “Now’s
not the time for me to make a change.” Although no change may be perfectly
appropriate, what troubles me is that I frequently sense a lack of conviction.
Instead of
identifying a list of objective reasons for maintaining one’s investment
position, time and again a fuzzy subjective reason is given or even no reason at
all. When this occurs, that’s when the reason not to change is typically just a
fear to change.
Personally, when I own a stock, sector or even asset class that is declining or disappointing my expectations, I go back to square one. Why do I own it? Is there a flaw in my analysis? And perhaps the truest test, am I willing to commit more money to it? If my conviction is low, I have likely made a mistake and it is time for a change. My investments are not my children; if someone calls them ugly, there is no reason to be offended.
For some totally incomprehensible reason, our mind loves to anchor itself in the shallow waters of the cost of our investment. As an example, just think of yourself as a visiting gambler in Las Vegas who has been fortunate enough to double your money. Now that you are playing with the “house’s” money, it’s great if you win more and no harm done if you lose the “their” money.
Or envision the opposite extreme where you are down half your allotted gambling money. All of sudden your goals change from winning to avoiding loss. The objective now is getting back to even and then you will quit and leave. Rationally, the mind should realize that the more time spent gambling the greater the expected and accepted loss should be. It is a basic mathematical probability that the casino will win over time. Thus the most likely outcome is that the gambler will dig a larger hole.
The parallel of both mental outlooks, winning and losing, is that the mind anchors itself to its original investment. Unfortunately the mind is also predisposed to anchoring when investing, perhaps even more so given the taxation of capital gains and losses. Great investors, on the other hand, worry little about their historical cost and worry a great deal about business fundamentals. Judge your investments not by yesterday’s cost basis, but rather by tomorrow’s return potential.
My ego
will just confuse me
Some day it's going to up and use me.
Pete Townsend
Have you ever noticed how confident market pundits are when predicting future investment returns: “this is a once in a lifetime buying opportunity” or “we expect the Dow to close the year at 11,150.” Just as our brain seems compelled to anchor around our cost basis, forecasting future events seems to prompt our brain to target on one outcome, not the multitude of possible scenarios. Making matters worse, our brain then becomes unusually confident in its forecast. Very few of us are willing to admit our defacto uncertainty regarding the actual future outcome. We would be much better served to instead forecast the wide range of outcomes that are more probable. The great economist and investor John Maynard Keynes perhaps said it best, “I would rather be vaguely right, than precisely wrong.”
Closely
linked with overconfidence is the problem of over optimism. Clearly
professional investors were far too optimistic when valuing the high-fliers of
the NASDAQ in the late 1990’s. It took thirty-five percent growth projections
into perpetuity to justify a valuation that allowed Cisco to obtain a market
capitalization greater than General Electric. As Warren Buffet stated, “It is
optimism that is the enemy of the rational buyer.” Unfortunately, as investors
we sometimes combine the two mental mistakes, resulting in an expected
investment return that is both too precise and too high.
The doctors X-rayed my head and found nothing.
Dizzy Dean explaining how he felt after being hit on the head by a ball in the 1934 World Series.
Regrettably, investors X-rayed technology, telecommunications, and mega capitalization stocks and found nothing. For many investors, they probably now feel, or wish they felt, like Dizzy after the bubble burst. Knowing that almost 80 percent of the top 500 companies sustained their investment value in this “bear market,” these investors should diagnose contemplatively the mistakes they or their advisors made. To paraphrase Winston Churchill, an investor that forgets the past is doomed to repeat it.