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Human Behavior and Investing: How Our Wiring Could Sabotage Us

By on October 14, 2015
Categories: D&Y UPDATES

Equity markets logged their worst quarterly performance in four years for the period ending September 30, 2015.  A laundry list of concerning developments caused investors worldwide to take shelter, selling risky assets now and asking questions later.  Primary concerns included the seemingly endless uncertainty about the Federal Reserve’s plan for interest rate increases, the slowing Chinese economy and the extreme volatility of its stock market, and intensifying emerging market turmoil related to plunging commodity prices and weakening currencies.  The combination of these issues led to a spike in global market volatility, particularly in the second half of August.

Asset class returns for the quarter and year-to-date were as follows:

 

Index

Asset Class

Third

Quarter 2015

Year-To-Date 2015

Barclays U.S. Govt./Credit—Int. Fixed Income

  0.9%

 1.8%

S&P 500 Large U.S. Stock

 -6.4%

-5.3%

Russell 2000 Small U.S. Stock         -11.9%

-7.7%

MSCI ACWI ex-USA Foreign Stock         -12.2%

-8.6%

S&P Global REIT Real Estate Securities

 -0.5%

-5.1%

 

It can be tempting to dwell on the current headlines buffeting financial markets, but we prefer to take a broader view.  Corrections are a normal and recurring part of the stock market’s price-seeking function.  The U.S. stock market has had an incredible run since March 2009, and until recently had not experienced a correction since 2011.  Even after this quarter’s selloff, the S&P 500 index is still 80% higher than it was four years ago.  The U.S economy remains relatively strong, with low unemployment and almost non-existent inflation.  Corporations have very high levels of cash on their balance sheets and continue to return capital to shareholders with dividend increases and share buybacks.  At current levels, stocks are trading relatively close to historic valuation levels in terms of price-to-earnings ratios.

The academic field of behavioral finance has a lot to say about how investors can learn to cope with volatile market environments.  In short, behavioral finance suggests that human beings are not wired like the rational subjects found in economics textbooks; rather, we have a multitude of behavioral heuristics that serve us well in most areas of life, but which are suboptimal for economic decision-making.  In this letter, we would like to examine three behavioral tendencies that frequently sabotage the best-laid plans of investors:  overconfidence, confirmation bias, and herd behavior Falling prey to these behavioral traps often leads to investment decisions based on emotion, rather than rationale and logic.

We will start with overconfidence and its close relative, confirmation bias.  Whether considering our driving skills, the talent of our children, or our investing ability, none of us are immune from occasionally overestimating our knowledge and abilities.  The example most relevant to investing is the belief that with little knowledge or homework, individuals can pick investments that consistently beat market indices—or can select managers who will do so.  Academic research has proven time and again that this simply is not the case, even with substantial experience and research.  Beyond overconfidence, many investors must fight a subconscious inclination to seek information and feedback to reinforce their pre-existing beliefs.  This confirmation bias makes it very challenging to break patterns of thought and behavior because it specifically leads one to seek and find support for even the most questionable investment ideas and to reject evidence that does not support his or her original thesis.  These tendencies can be tempered by exposing oneself to a wide variety of thought and opinion, sharing financial decisions with others, and seeking critiques to one’s own decision-making process.

Herd behavior is our innate tendency to base our decisions on the actions of others.  When the market sells off as it has lately, our fight-or-flight instinct tells us that the safest thing is to follow the herd and sell our investments (as it seems everyone else is doing!).  By eliminating the possibility of further losses, selling alleviates our short-term pain. Herd behavior is comfortable because we are part of a crowd; we do not stand out and look different.  In the extreme, information cascades can drive herd behavior, taking markets to astonishing highs and lows—think the dot-com boom in 1999-2000 or the market lows of 2009.  The challenge in taking counsel from others is not to abandon your own instincts, common sense, and reason.  In the long run, conventional wisdom is often on target.  But in the short run, crowd behavior creates dramatic shifts in tastes and actions, commonly leading to costly overreactions and missed opportunities.  While knowledge is indeed power, too much noisy information can be both counterproductive and destructive.  Studies have shown that investors who tune out most financial news fare better than those who subject themselves to an endless stream of mostly meaningless information.  Tuning out the noise of the media provides fewer opportunities to react emotionally to the natural ups and downs of financial markets.  Rather than following the herd, our focus for each client remains maintaining an appropriate asset allocation, diversification, keeping costs and taxes low, and disciplined rebalancing.

Finally, as we near year-end, we would like to remind our clients of a few tax-related matters.  We may be consulting with those of you who are obligated to take required minimum distributions (RMDs) from IRAs and other retirement accounts by December 31st.  Please inform us of any IRAs you own that are not managed by our firm so we can take them into account when calculating your RMD.  If you plan to make charitable donations of appreciated stocks or other securities in 2015, please notify us as soon as possible—ideally no later than the first week in December.  Also, if we are not currently reporting information directly to your tax preparer and you would like us to do so, please provide us with his or her name and contact information (including email address) by the end of the year.

We appreciate our clients’ trust and confidence in Dowling & Yahnke and invite you to contact us with any questions regarding your finances.

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