There, I said it. Yes, I wish I could pick lottery numbers too but, sadly I cannot do that either. HOWEVER, in the behavioural world of irrationality, sometimes we can identify emotion and look the other way. This has happened and benefited us most in the past quarter. Emotion has been everywhere. Consider a few examples of human emotion at work that we have experienced and seen in action:
Person A sells TD Bank stock yielding about 5% and buys a TD GIC Yielding 1.5% - for fear of the market. The outcome is a lower yield and TD bank goes up 8%.
Person B reads a story on cash as an asset class from a self-proclaimed short seller and goes to 100% cash in his/her account. The outcome is that the market moves 5% higher.
The DOW hits 18,000 and people are angry because it is not fundamentally supported. The outcome is that the angry investors start buying back in because they do not want to miss the party.
The list could go on, but you get the drift. Emotional response and emotional behaviour is bad for investing. Period.
Consider a recent bidding war for a townhouse in Toronto. Listed at $1.1m (already overvalued), the bidder a friend of ours thinks “Okay, I’ll go in at $1.3m and get the deal.” The townhouse sells for above $1.4m. The buyer must have really loved this place or was desperate – an even harsher emotion when it comes to investing. If you want love, go on a date. Maybe in the long run the buyer will prevail and this townhouse will be worth more, but it leaves us scratching our heads around emotional driven transactions. For the record, we do not know where the price of this townhouse will be in the future either.
This gets us back to the root of our writing. Forest Gump said “stupid is as stupid does”. He, in the pop culture era of sayings, is likely right on some levels.
Where is the control?
You do not need to be able to control your emotions to be an investor, but we do believe you need to manage them to be a successful investor. Anything involving money elicits a lot of emotion, whether it is your money or someone else’s. These emotions can create behaviours that are detrimental to successful money management. Below we have highlighted a number of common behaviour biases that pose a risk to longer-term returns. Knowing and understanding these biases is the first step in managing their influence.
Simply put, this bias makes us put greater emphasis on information and events that are most recent. Memorable situations stay with us for a long time, and they can affect how we see and interpret our surroundings as well as our investments.
Some real world examples include lotteries, which are very popular, despite the huge odds against winning. By heavily promoting jackpot winners, we hear and remember who they are and where they are from. Another example is a car accident. If you or a close friend has been in one recently then you may begin to observe that the roads are getting more dangerous. Or, if you turn on the 6pm news, you will probably believe that the streets are more dangerous and that murders are more common than they actually are. Most of us are in a constant media overdose. What we see and read affects our judgement and those in the press that control the message, including the financial press, are fully aware that they are preying on viewers’ fears.
The availability bias makes us over emphasize today’s news and, as a result, greatly discount the past. From an investment point of view, this can be seen in how shares react to unexpected news such as earnings surprises or changes in management. A company that has consistently delivered results misses one quarter and is dramatically punished as investors discount past successes and focus on one quarter. Knee-jerk reactions can prove to be untimely, especially if the company starts to deliver again.
Newlyweds often believe their marriage will last a lifetime, even if they are told that four in ten first marriages in Canada end in divorce. New graduates are inherently more optimistic about how long it will take to find a job and how much money they will make. Everyone is optimistic to some degree. If not, the problems of the world would crush you and cause you to wither away and die.
This same bias is evident in money managers who hold onto stocks that are underperforming because they are overly optimistic things will turn around. The glimmer of positive attributes blinds them from recognizing the glaring red flags.
As humans, we easily brush off negative news and effortlessly apply positive updates to our decision making.
To avoid this from hindering our portfolio returns, we constantly reassess positions and avoid group think biases. We do this by having “revisit levels” on investments, which come in the form of an absolute price or a percentage decline from a peak. We also often do “bull / bear” debates in which one group member will argue in favour of buying or holding a stock and another will take the opposing stance.
With some similarities to optimism bias, confirmation bias causes investors to focus more heavily on information that supports a pre-existing view or opinion. Meanwhile, information that is counter or refutes your view is discounted greatly. Working in a team can help combat this bias, as long as the team is not filled with ‘yes’ men or women. A good exercise is to revisit and debate existing views, weighing evidence on both sides. We often have one view as a bull and one as a bear to create a debate and to test existing opinions.
This bias is best explained in an example. Consider that it is your first time at an outlet mall in sunny Fort Lauderdale. On one side of the parking lot is a discount retailer selling marked-down designer clothes, with a line up out the door. On the other side is the exact same discount retailer, but with only five people inside. Typically, you would head over to the one with the lineup, assuming the patrons must know that this place has the better deals and inventory. However, this could simply be the fact that the second person who arrived that day followed the first person into that store and this pattern continued until the lineup was out of the door. Leaving the other store ripe with deals on your favourite Hilfiger boxers or Sean John jeans.
This is one of the most prevalent biases in money management. Retail investors will see a stock start to fly like Netflix, Amazon or Facebook. They start piling in after much of the rally has already occurred, fearing missing out on further profits. This even happens with professionals following momentum and volume-based technical. As a stock moves higher on strong volume (more people piling into it), you see more and more people follow the trend and further propagate the buying. Consider how Valeant became one of the most widely held securities across hedge funds.
It is important to have a process to filter and vet the biases that get in the way.
We have just touched on a few behavioural biases that can pose a risk to an investment process. Whether as an individual investor or money manager, understanding the risks and incorporating steps into your investment process to mitigate these risks can help in the long run.
We believe there are inefficiencies in the markets, many of which are created or magnified by behaviour biases.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.