Investors Mistakes – Part II - Behavior Biases

My last post outlined Barry Ritholtz’s 10 investor mistakes and then provided some solutions.  In this post, I will focus on cognitive errors investors make.

I recently read an article entitled “Investors’ 10 Most Common Behavioral Biases” by Robert Seawright.  I really think behavioral finance aspects of investing are vastly overlooked, especially when it comes to Modern Portfolio Theory and a total set it and forget it allocation.  Below, I summarize the list and suggest possible ways to correct such biases:

1. Confirmation Bias – get to the conclusion first and then find facts to support it.  Solution:  Seek out information that runs contrary to your current opinions and conclusions.
2. Optimism Bias – you believe you are less at risk of experiencing a negative than everyone else.  Solution:  Focus on the capital you have at risk.
3. Loss Aversion – losses feel much worse than gains feel good leading to poor investment decisions (note: this conflicts with number 2 and as the author states “we tend to make bold forecasts but timid choices”).  Solution:  Have a plan in place in the event you start to experience losses.
4. Self-Serving Bias – good things happen because of you, bad things are someone else’s fault.  Solution:  Be humble regarding gains, owe a part of it to dumb luck, have a plan on the way down so losses are in your hands.
5. The Planning Fallacy – we overrate our own abilities, underestimate the process, and overestimate the gains.  Solution:  Have an objective look at the risk/return profile of your investments, realize the future won’t replicate the past, and be cognizant of hedging costs.
6. Choice Paralysis – too many choices lead to decision paralysis.  Solution:  Reduce the number of your investment holdings and focus on asset class over managers.
7. Herding – herd behavior.  Solution:  Be cognizant of the herd, but don’t follow it without a logical reason.  Realize investment managers also follow herd behavior (e.g. they get hammered less if they are wrong when everyone else is, but are hammered harder if they are wrong when the herd is right).
8. We Prefer Stories to Analysis – people tend to prefer a narrative to data: it’s easier to understand.  Solution:  Analyze data, look for trends, and make objective decisions based facts, not stories.
9. Recency Bias – extrapolate recent events into the future indefinitely.  Solution:  Filter noise and look for signals.  Generally, ignore most analysts.
10. The Bias-Blind Spot – not recognizing we have cognitive deficiencies.  Solution:  Read the attached article and this blog post. 

Next up, my own additions to the last two posts.

Investor Mistakes – Part I – Conventional Mistakes

Recently there has been a wave of good articles outlining investor mistakes.  As a result I thought I would outline the two pieces I read and then in a separate post, add my own.

The first piece is from Barry Ritholtz entitled “Investors’ 10 most common mistakes”.  I present my Ritholtz’s mistakes and then suggest a solution:

1. High fees – over time fees can be a big drag on returns.  Solution:  Seek out investment managers with lower fees, ask for transparency, and avoid complicated investments with higher fees.
2. Reaching for yield – picking investments based on what they kick out in income.  Solution:  Always keep an eye on the risk vs. return trade off. This has been a common and BIG mistake by many investors in the last five years investing in CDO’s and like securities.  On the equity side look for quality, not yield.
3. Your own worst enemy – making investment decisions based on emotion.  Solution:  I like Mr. Ritholtz’s solution, if you need to “feed the beast” do so with a small amount of capital so as not to sabotage your portfolio.
4. Mutual funds vs. ETFs – mutual funds charge higher fees than ETFs.  Solution:  Be diligent in your active management selection and use ETFs as a foundation in your portfolio.  Anywhere from 15 to 30% of active managers have outperformed the indexes, depending on the asset class.
5. Asset allocation vs. stock picking – how you allocate to asset classes matters more than security selection.  Solution:  Give a greater weight to what asset classes you are in, paying particular attention to risky assets and realizing in times of crisis or euphoria they move together making security selection inconsequential.
6. Passive vs. active – most active managers struggle to beat the passive benchmark given fees.  Solution:  Similar to #4.  Again, thoroughly comb through active managers, know their strategy, be aware of fees, check their performance, and, most importantly, make sure qualitative factors are in place for repeatable success.  DON’T CHASE RETURNS!
7. Not understating the long cycle – markets move in secular cycles.  Solution:  Be cognizant of what is going on currently; however, never lose sight of the secular trend.  Realize strategies that work in bull cycles won’t necessarily work in bear cycles and vice versa.  Additionally, realize that bull market runs exist in secular bear markets and vice versa.
8. Cognitive errors – we suffer from many cognitive deficiencies which can present themselves when we invest.  Solution:  Too much to cover in a couple of sentences. I will expound on behavioral mistakes more in my next post. 
9. Past performance and future returns – chasing the hot money and not taking into account qualitative factors.  Solution:  Know the managers you are investing in and whether the past performance is replicable, luck, or more on beta (asset class performance) than alpha (security performance).  Don’t chase purely based on performance!
10. Get what you pay for – paying for advice or services you can DIY and/or finding the right people.  Solution:  Seek credible trustworthy referral sources. Interview several advisors and determine what you get for what you pay. Most importantly make sure it feels like you can develop the chemistry required for a successful relationship.   

Up next, various cognitive errors we make.

Europe Again & Again & Again – Part III, Some DIY Tips

Given all the news that comes out of Europe, I figured it would be a good idea to provide readers with a quick way to find easy to read news stories and then see how markets react. 

First, here is some good source material from the NYT.  I choose Spain and Italy given they are the rage right now. The pages are set up rather nicely, with a summary of all relevant information at the top, followed by the newest NYT articles on the bottom:

• Greece
• Spain

Next, when a new piece of information comes out how will the markets react?   I like to follow the yield on government bonds.  Bloomberg provide 10-Year yields and I picked three of the riskier Euro nations and then Germany as a way to compare:

• Greece
• Spain
• Italy
• Germany

Basically if things in Europe are worsening riskier Euro nations will have their yields rising and Germany should have its yield falling (note: this might not hold in the remote worst care scenario). 

There is also Intrade to see a market prediction on a county leaving the Euro.  Without getting into detail, essentially just look at the % chance.

There are obviously many more places to mine for data.  I think these are the most basic and direct. 

One thing to note, it appears the trend is that markets are reacting less and less favorably after every “positive” announcement.  To me this indicates markets aren’t buying what Europe is selling.  Again, as I mentioned in my previous post, I don’t think this will happen until Germany backs substantial systemic change. 

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

This is bigger than any news out of the EU in awhile.  While the restructuring I think is needed, it is certainly a step in the right direction:

1. A step toward UNITY.  This is key, all countries need to start moving together, not apart.
2. By recapitalizing the banks directly through the ECB, the risk of the worst case scenario credit crisis scenario (bank runs) appears to be reduced, although not eliminated.  

Europe Again & Again – Part II, Too Much of Nothing New: What to Expect

When I say “nothing new” I mean anything that isn’t a total restructuring of the Euro.  This should be approached with either new rules/institutions (e.g. Eurobonds, EU backstop, etc.) or with a change in members (e.g. weaker members leave, Euro disbands, etc.).   Status quo will not do - something new, something systematic is required if some semblance of the Eurozone is to survive.

What does not constitute something new is what I outlined in my last post – Spanish bank bailout, and  a Greek coalition to stay in the Euro.  These are stop gap measures that will only kick the can down the road.  The market apparently agrees.

So if Europe continues to kick the can down the road what should we expect?  More of the same from late last summer to now:

• Downward pressure on the Euro vs. Dollar (i.e. the Dollar continues to strengthen versus the Euro, making your European vacations cheaper and our exports more expensive)
• Steep VIX futures curve
• The VIX is a forward looking volatility measure.  The steep curve implies the market expects volatility to be greater in the future than it is now.
• Upward trend in yields of weaker EU countries (Greece,  Spain,  Italy)
• Downward trend in German yields
• Low Treasury yields
• Choppy equity market, perhaps range bound

How long with this continue? I am not quite sure, but I would think the above trends will probably hold until there is a resolution one way or another.   That isn’t to say there won’t be movements against the trends whenever some news comes out, just that over the course of “kicking the can down the road” they will persist. 

The ball is in Germany’s court.

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

I will comment more on this in my last post of this 3 part series.

Europe Again – Part I, Too Much of Nothing New

While I would like to stop writing about Europe, unfortunately it doesn’t appear that I can.  I gave my most recent breakdown here, here, and here.  Since then, Spain announced a bank bailout and Greece had new elections.  Here is what has happened since my last blog:

Spain – “Euro zone finance ministers agreed… to lend Spain up to 100 billion euros ($125 billion)”

Greece – “Greece’s two traditional political rivals are in a race to forge a coalition as the state’s cash dwindles, bank deposits flee and Europe demands renewed austerity pledges before releasing more emergency aid… New Democracy won 129 seats in the 300-seat parliament, according to Interior Ministry projections with 99 percent of the vote counted. Pasok, which has alternated in power with New Democracy over the past four decades, won 33 seats, enough for the two of them to forge a coalition that backs the creditors’ austerity demands.”

So what do these two events mean?  It appears not a whole lot.  Markets were unmoved by either.  The Spanish bailout at first created some optimism but that quickly dwindled.  Why?

I can’t answer with certainly, but it would seem both of these are stop gap measures that do nothing to address the major concern of the Euro – disconnected monetary and political/fiscal policy (via Pragmatic Capitalist, Goldman Sachs).  So where is the game changer?

There is a lot of noise, so it’s difficult to tell when something substantial (like our TARP program) will change the dynamic; however, one thing is very clear: Merkel will be the key.  Whenever Germany starts talking and acting on the inevitable wholesale change that must develop is when there will be some resolution.  

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development:

“Euro-area leaders asked for proposals this year to unify banking supervision and soup up the ECB’s powers. They referred to a clause in the EU treaty that allows them to give the ECB prudential oversight of banks and other non-insurance financial companies.

The move paves the way for the European Commission, the EU’s regulatory arm, to augment its proposals on deposit insurance, capital requirements and how to handle failing banks…

Once Europe establishes a single banking supervisor, leaders said they may allow cash-strapped lenders to be recapitalized directly instead of through their home governments. ”

I will comment more on this in my last post of this 3 part series.