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Submitted by: Paul Palmer
Paul Palmer is the Managing Partner of Cypress Advisory Services, Ltd, LLP, a comprehensive wealth management firm in Houston, Texas. Paul is a 23 year veteran of the financial services industry. Both he and his partner, Kurt Box are CERTIFIED FINANCIAL PLANNER® practitioners. The firm's comprehensive approach and unique institutional money management style give its clients peace of mind along with cutting edge financial advice.
In Part 4 of this series, we discussed 4 of the 7 common emotional biases people exhibit. As a review, emotional biases originate from impulsive feelings or intuition (as opposed to conscious reasoning) and so are much more difficult to correct. The final 3 errors are denial, herding or groupthink and fear and greed (never!).
Denial
“The refusal to choose is a form of choice; disbelief is a form of belief.”
We all know what denial is and we’ve all had an experience with someone who was in denial. How frustrating that can be! But how does denial relate to poor investment decisions? Denial relates closely to anchoring (see Part 2). Anchoring is when people have in mind (memory) some reference points (anchors). For example, a previous stock price, or price trend. This might block their mind to situations changes that makes those past references obsolete. They even often suffer from denial, by rejecting new facts that are contrary to their beliefs and preconceived ideas. Denial can occur when you refuse to sell that stock that has a huge loss and which you know is not turning around and has little upside. You refuse to take the loss because that would be admitting a mistake; you are in denial. Investors don't cling to losers because they feel for the underdog, certainly. They simply don't want to admit their mistakes. They go into denial. By not unloading lousy stocks, an investor avoids the obvious pain associated with selling at a loss as well as the potential pain of seeing a poorly performing stock that he's dumped turn around. People are also in denial with regard to more mundane issues. Here are four red flags of financial denial:
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You hit the same financial potholes over and over, and you're not sure why (always paying late fees; chronically short of cash, etc.).
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You find yourself behaving in ways you know you shouldn't (putting another suit you "need" on your card, eating out when you promised yourself you'd cook at home, buying that Mercedes, etc.).
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You're financially stuck and can't get unstuck (unable to consistently save, or the minute you do, you're right back in it again).
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You find yourself using any of the following rationales to explain the above:
I'll deal with it."
"Other people do this all the time."
"Right now, this is more important."
"I need to."
And the worst: "I don't care; I'll figure it out later."
If any of those behaviors sound familiar, you're probably in some amount of financial fog, and the reason you've obscured reality is because something is making you really uncomfortable.
Herding or Groupthink
Without herding, we would never have experienced the stock market bubbles of 1929, 1966, 1987 and 2000. Speculative condos in Miami would not be selling, twice, before they are built. Herding is when investors reflexively do what other investors are already doing. Widespread herding behavior by a group of investors can worsen volatility and touch off panicked buying and selling that do not reflect true economic conditions and market values. Herding can be fully rational from the point of view of an individual investor when the investor may have only limited access to direct information about asset returns and therefore needs to learn from the actions of others. Sometimes, the best thing an uninformed investor can do is follow the actions of more informed investors. However, in today’s world when speaking of the broad markets, information is certainly never lacking. Many times it’s the feeling that your going to “miss out” that drives herding.
Now if you tend to agree that individual investor’s herd take a closer look at professional money managers (i.e. mutual funds). Fund managers' compensation may be linked to the performance of the fund they manage relative to those of other funds (or benchmark indexes) of the same type. This may prompt managers to try to avoid falling too much behind their comparator funds/indexes, which would lead them to invest in a portfolio of assets that never diverges very much from their comparator funds' portfolios. As a side note, fund flows (or new money put into the fund) can also effect their compensation. Falling behind a benchmark for any extended period of time can lead to outflows and thus a smaller income for them. This is why we carefully analyze the holdings and individual security selection processes for the funds we utilize for our clients and why it’s possible they may under perform their “benchmarks” for extended periods of time. If we are interested in getting the benchmark return we would simply utilize a low cost index fund (or exchange traded fund (ETF)).
Fear and Greed
Fear and greed are common tripping points in all aspects of people’s lives. Investing is no exception. In a 2004 study of 80 anonymous day trades it was found that subjects whose emotional reaction to monetary gains and losses was more intense on both the positive and negative side exhibited significantly worse trading performance. Their large sudden swings in emotional states seemed especially detrimental to cumulative profits-and-losses.
In fact, the source of many other irrational biases is fear and greed. This reaches from overconfidence to overreaction to loss aversion to regret to lack of self-control to hindsight and to denial. If only we weren’t so greedy! You might think this would be a good trait in investing, but it is not.
Paul Palmer, Jr. and Kurt L. Box are Investment Advisor Representatives with Cypress Advisory Services, Ltd., LLP, a Securities and Exchange Commission (SEC) Registered Investment Advisor.
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