Investing is not easy. First, I would like to start with a statistic: four out of every five years, the stock market is up, and the average up year is better than the average down year. With a statistic like that, it sounds as though the stock market is some rigged casino where the longer you stay, the more you win. Well, statistically, that argument has some backing. As I write this, over the past 50 years, the S&P 500 price level has increased roughly 6.8% annually adjusted for inflation. A dollar invested in the S&P 500 fifty years ago would now be worth about $27.12, $100 would be worth $2,712, $1,000 would be worth $27,120… you get the idea!
So then, what makes investing so hard? One can argue it is the complexity of the financial markets and the time and research one must put in to become knowledgeable on investing. That is a fair argument, and there is a learning curve associated with investing. But I would argue that another factor is perhaps more meaningful at making consistent, successful investing difficult over a sustained period. That factor? Human emotion.
Going back 30-40 years, behavioral finance was an overlooked segment of investing. But, behavioral finance can provide an understanding of the impact of personal biases of investors. Below are details on three common biases and how they effect even the best investors.
Loss aversion is the most common among investing behavioral biases. Simply put, loss aversion is the tendency of investors to be so fearful of losses that they focus on avoiding a loss rather than on making a gain. Put another way, an investor is more emotional about large losses than large gains. For this reason, many investors, after suffering significant losses in a downturn, sell out of the stock market in an attempt to stop further losses. While this move could end up working, we like to say around the office that you have to be right twice if you are trying to time the market. You have to be right once when you are selling and once when you are buying back in. Being right twice is harder than being right once.
So how does one “fix” loss aversion bias? The bad news is, there is no fix. We are all humans, and we all have emotions. But, having a clear understanding of your risk tolerance and how risky your portfolio is relative to your risk tolerance can help you avoid dramatic portfolio decision-making.
As the name implies, the herd mentality bias is the investor’s bias to follow the trends of what other investors are doing. In its most extreme examples, the herd mentality bias leads to bubbles. A perfect example is the dot-com bubble of the late 1990s and early 2000s. Many companies without a sound business model or revenue saw their stocks skyrocket because of “herding”. People saw other people making money in technology stocks and decided to pile in, resulting in a bubble that peaked in March of 2000 and bottomed in October of 2002. The tech-heavy Nasdaq lost nearly 80% of its value over that short period.
Herd mentality bias still exists today, with the most recent example being the wild Gamestop saga we saw earlier in the year. The primary remedy to the herd mentality bias is to do your own research. Momentum investing can be successful if an investor does their research and the company is financially fit or has growth potential. Disasters happen when herds pile into stocks that are undeserving of investments based on their financial fundamentals and business outlook.
The narrative fallacy limits our ability to evaluate information objectively. Everybody loves a good story. Why do we love stories? Typically, stories have emotional content which appeals to our subconscious. Because of this emotional component, they are very easy to remember.
But, some investors love stories so much that some let their preference for a good story cloud the facts and their ability to make rational decisions. This means that an investor may be drawn towards a less desirable outcome simply because it has a better story. A prime example is value investing. As you know, from working with Quaker, we are value investors. In terms of the narrative fallacy, value investing is essentially the opposite. With value investing, investors look for bad stories that may be ending or bad stories that may be overblown. This could present an investment opportunity if research supports it. Many investors shy away from value investing because they only want to invest in companies with good stories.
Avoiding these biases altogether is nearly impossible because we are all human, after all. Warren Buffet has many fantastic quotes, but I thought the following on the “Rules” of investing was fitting: “Rule Number 1: Never lose money. Rule Number 2: Never forget Rule Number 1.” Catastrophic decisions tied to behavior finance will negatively affect your investment return and your financial goals. By understanding and being aware of these biases, an investor can avoid making catastrophic decisions and sustaining life-altering investment losses.