The Biggest Factor In Making Profitable Investments: You

by: JAR Financial Management

One question asked of investment professionals that I often hear is "What is the most important thing to do to become a successful investor?" Answers often range from analysis of various ratios to various investment theories such as contrarian investing. Most of these answers are sound but in my view fail to answer the question. For example, one theory is simply buy-and-hold. There are many studies today that support this theory. Various studies will show that the market has averaged about 8% per year (of course this varies over the time period studied). However, the average investor only makes 3% - 4% per year. I believe the correct answer to the question stated above explains why this disconnect happens. Before committing funds to an investment all investors must first analyze the most important aspect of investing, you. I believe Benjamin Graham states it best in the introduction to The Intelligent Investor,

"For indeed, the investor's chief problem - and even his worst enemy - is likely to be himself. This has proved the more true over recent decades as it has become more necessary for conservative investors to acquire common stocks and thus to expose themselves, willy-nilly, to the excitement and temptations of the stock market….We have seen much more money made and kept by 'ordinary people' who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock market lore." (Benjamin Graham, Page 8, The Intelligent Investor)

One common flaw regarding many of the theories stated above is that they are based on idealized financial behavior. Behavioral analysis has assumptions based on observed behavior. In this article I start by providing you with an overview of behavioral finance. I end the article with questions to ask of yourself and/or your advisor and ways to start recognizing investment biases you may have so you can invest accordingly. Please keep in mind, a bias is not detrimental, it only becomes so when you choose to ignore it. (There are more biases than what I list below, however, these are common ones that I frequently come across)

From an individual stock selection perspective, the most common bias I have witnessed is when individuals only notice information that interest them or confirms their thoughts. This leads them to ignore conflicting information. One recent example of this for stocks has been Apple (NASDAQ:AAPL). A few analyst wrote since last year about Apple facing margin contraction and they were ignored because Apple "could do no wrong." We tend to forget the saying that a good company does not always mean a good value for the stock.

The second most common bias I have seen for individual stocks is referred to as anchoring and adjusting. This occurs when an individual lets price determine their buy/hold/sell actions instead of fundamentals. The most common illustration I have witnessed for this is purchase price. The first example occurs when an individual buys a stock let's say for $20 per share and the stock subsequently falls to $15 per share. They often say, "Once the stock hits $20 again I'm going to sell the stock." The second example is if we buy the same stock at $20 per share but instead it proceeds to move higher. We often state a specific target such as 30% and say, "Once it hits $26 I'm going to sale." Again, these decisions should be made on fundamentals not price. If you buy a stock because you believe it's a good value and it declines for no specific reason hold it.

The anchoring and adjusting bias leads to what I believe is one of the toughest biases to overcome. This is loss aversion. It has been proven that individuals overwhelmingly prefer to avoid a loss than achieve a gain. As investors, this leads us to hold losers and lock in profits (locking in profits could mean to sale winners to early or lock in profits through various derivative transactions). A term used to describe these actions is the "house money" effect. I will relate this bias to a casino. Often times when we gamble and lose we get upset and feel that we've lost money. However, when we win we view our winnings as luck and that it's not really ours. I can not tell you how many times I have been in a casino and heard someone say, "I'm winning so I'm playing on house money." This mentally leads to two destructive behaviors. Either the person will be too conservative and pull their money when the odds are in their favor or say "it's the houses' money" and take on more risk than they normally would or should. We see this same action with stocks. If an investor's stock goes up they often sale or take their gains and invest them too aggressively, therefore, adding more risk than normal to their portfolio. Never believe you are playing with "house money". It is your money.

Two Biases we often see that have to do with control are illusion of control and lack of self control. The most common form of illusion of control bias appears in the ownership of stock an individual works for. They may feel they have a say in the company's outcome, but this view is flawed in two ways. First, most public companies are too large for any one person to control unless they are very high up in company management. Second, stock prices are subject to market forces which no individual can completely control. Self control bias entails adhering to a theory such as long-term investing but allowing short-term events to affect us.

I have witnessed many times investors, friends and family members starting investment plans then not sticking to them even though rationally they should. How many times have you heard someone say they are going to start a work out plan. Rationally, they should already be working out to stay healthy and continue this as long as they physically can. However, what we witness is that individuals start a plan to get healthy only after a bad diagnosis. Then they start a plan, proceed to do it for a few months then stop. People bring this to the investing world as well. Do not let yourself get caught in this trap because I can almost assure you that your investment results will not be what you thought they should be.

One area I am often asked about is how to overcome lack of self control when initially designing or reallocating a portfolio. Following is a brief story I will share with you.

While I was in training to become a financial advisor I was instructed to account for this bias by asking the following questions, "If your portfolio lost 20%, how would you feel?" I believe this approach is flawed. I believe a true dollar amount should be stated because it makes the loss of value tangible. If you have a $500,000 portfolio losing 20% does not sound as bad as losing $100,000 (this is framing bias that advisors use which I write about later on). If you ask yourself the same question and you say I can lose $100,000 but I would panic if it were more than that, you should allocate your portfolio (or have your advisor allocate it) to target a max potential loss of value of $50,000. This is especially true if you've never had your account lose this much before. We often tell ourselves that we won't panic but if you've never experienced a dramatic downturn you may not know how you will truly act.

The bias I have witnessed most often from a portfolio perspective is referred to as inertia and default. This is especially true for retirement accounts such as 401k's. This bias refers to setting an initial allocation and never revising it or simply selecting the default selection. In 2009 I often heard new clients complain about their retirement accounts losing 30 - 40% in value. I would ask when was the last time they reviewed the allocation and most of the answers were between eight and fifteen years previous. An individual who is forty will most likely have a different allocation than someone who is fifty or fifty-five. To help combat this bias companies have developed target date funds. These funds are designed to automatically reallocate stocks throughout the years. One must take caution though, these funds are a one size fits all solution. You're plan should be based on your specific circumstances.

The last bias I most often is delivered by advisors and participants in the investment community. This is framing bias. Framing bias is how questions, presentations, or news event are presented to you. Often they are presented in a way to benefit the self-interest of the presenter and not yourself. I provided an example earlier of how an advisor will often state risk in terms of losing a percentage of your portfolio. In that example I used twenty percent and a $500,000 portfolio. When dealing with these two numbers, our minds often trick us because twenty is far less than 500,000. As strange as it sounds I have witnessed this first hand. I have been speaking with numerous individuals in the past were I will be comparing two investments and unconsciously say, "Fund A could lose roughly 20% and Fund B is similar in that it may lose about $100,000." The most common response from people is that they would rather invest in Fund A because it sounds less risky. Don't believe me or believe you would not fall victim to this? Pick up any mutual fund advertisement. On it you will see the 10 year average and the standard deviation of returns. For example, ABC fund has a ten year average of 6% with a standard deviation of 12%. You will never see on the advertisement what this actually means and most are not aware of its meaning. What it is saying is that over a ten year period, ABC has averaged 6% and assuming a normal return distribution there is a 95% probability in any given year that the fund will return -18% to 30%. This second version sounds a lot more risky than simply stating the average and the standard deviation. Add the actual dollar amount to the potential loss and most investors would run from this investment.

Another way Advisors use framing bias is how they lead into a presentation. For example, I can start a conversation with the following description of an investment, "This investment is a minimum of eight years. The interest rate on this investment is going to be between 2% and 8% per year. The interest is also tax deferred and the company issuing this investment is AA rated." This investment is an equity indexed annuity. If I would've started the conversation with the word "annuity" most people would run for the hills because they have a personal bias towards them even though they don't understand the differences between them. The same person that would not invest in the annuity described above may invest in an eight year variable rate bond with a min. rate of 2% and a cap of 8% issued by a AA rated company. However, the two investments with respect to time period, credit rating, and potential return are virtually the same. I have also witnessed advisors who chastise investments, for example annuities. They do so because their companies do not offer them and therefore they can not get paid on them, not because they are poor investments. If an advisor is trying to persuade you something is poor they will frame it using negative words. For the investment they are guiding you towards they will use positive words, even for the negatives in the given investment.

To see how news events are framed I will use a recent event. A few months back, I believe the month before the election, unemployment dropped to 7.8%. This story was spun in one of two ways depending on the self-interest of the news outlet you were observing. If the news company wanted to make it sound like this was a great accomplishment they would be parading it in headlines and use it to start their telecasts. If they wanted to demonstrate how poor it was they would immediately point out and emphasize that the labor participation rate was at an all time low and how the number of newly employed individuals does not keep up with the pace of population growth. Our job as investors is to take the facts, if calculations are involved understand how they can be manipulated, and from there develop an outlook on how we can position ourselves to make profitable investments. One word of advice, try not to only pay attention to things that interest you or confirm your thoughts.

One last bias I will touch on is hindsight bias. I wanted to include this in the article because it often has to do with making ourselves feel better and hinders us from learning and making better decisions in the future. We as people often try to rewrite history instead of learning from it. In the investment world the most common phrase I hear involving this is, "I knew I should've made that investment." This is a statement that makes us feel better about our decision not to make the investment. Bottom line is if you knew you should have made the investment, you would have. Take your decision not to invest and understand where your analysis was wrong so that way the next time you do make the investment. The point I am trying to make here is, be real with yourself.

The most important part of this article is how to deal with biases which I provide brief steps below (this list is designed as a general guide and should be added upon based on your situation and experiences):

Step 1: Beware of the bias. This is the hardest step because it involves being "real" with yourself. It's also the hardest because it requires research. In this article I have touched on just a few biases. There are books that provide more biases and more details on these biases with very specific details on how to over come them.

Step 2: Ask questions either to yourself or to your advisor. Why am I making this investment? Does this investment fit into my overall plan? What are the risks? What might go wrong? When do I sale/What is my exit strategy? Over time this list of questions should build as you gain more experience.

Step 3: Keep records. This doesn't mean to just keep statements that show numbers. Actually keep records of the answers you provide in step 2. This should be done for investments you make and do not make. This should also be done for hypothetical trades that you may be thinking about but are not 100% sold on making the investment. Constantly review these records, remember this saying "out of sight out of mind." Keeping records does nothing if you do not occasionally review them.

Step 4: Post investment analysis on both good and bad trades. Learn, learn, learn. The good thing about finance is that it is so expansive that you can never know everything about it and there is always something new to learn.

Remember not all biases are bad and some you will not change. The key is to understand the bias and plan accordingly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.