The Mentality Of An Average Investor Part IV

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Includes: DIA, IWM, QQQ, SPY
by: Yicheng Lin

Summary

Representativeness generates excessively extreme forecasts, and anchoring leads to excessively moderate forecasts.

People think that they are smarter and have better information than they actually do.

The illusion of control: people behave as if their personal involvement can influence the outcome of chance events.

Researchers show that trading diminishes the return for investors.

The Mentality of An Average Investor series will talk about the biases and heuristics of average investors. This series will mostly use interesting surveys conducted by readers to show common misconceptions and biases. Most of the material is taken from the behavior finance course taught by Ling Cen at University of Toronto. Although the entire series is written by me, I would like to credit my professor for the valuable life lessons and investment ideas in this series.

This is part IV of the series. If you haven't read the first three parts, I would highly recommend you to check them out. Here is Part I, Part II and Part III.

Anchoring and Adjustment:

Kahneman and Tversky (1974) argue that when forming estimates, people often start with some initial (possibly arbitrary value) and then adjust away from it. This results in insufficient adjustment and "anchoring" too heavily on the initial value, no matter the first piece of information is relevant or not.

Anchoring contrasts with representiveness but they both leads to extremity. Representativeness generates excessively extreme forecasts whereas anchoring lead to excessively moderate forecast. Whether representiveness or anchoring dominates the forecast depends on the salience of the anchor. The greater the salient, the greater the likelihood of anchoring dominating. An interesting founding that researchers is that previous forecasts are more likely to be a salient anchor than previously announced earnings, because of the time and work involved in the creation of the forecast in the very first place.

52-Week-High/Low effect:

George and Hwang (2014) found that the nearness to the 52 week high can be used to forecast future stock price. Their findings are:

When the stock is closer to its historical 52 week high, investors tend to anchor on this value and think the likelihood to exceed 52 week high is low. This leads to excessive selling when the stock is near its 52 week high and make the stock undervalued.

The opposite effect goes for 52 week low, when stock prices are close to the historical 52 week low, investors anchor on this value and think the likelihood to go below 52 week low is low, thus making the stock overvalued.

Another place where you can find anchoring is in the M&A space. Baker, Wurgler and Pan (2012) did a research on acquisition price and found that overwhelming amount of acquisitions are made at above the stock's 52 week high.

Variable in the figure=(offer price-52week high)/price before the bid

Source: NYU Stern School of Business

An Interesting Survey.

Investor Overconfidence:

Overconfidence: unwarranted faith in one's intuitive reasoning, judgments, and cognitive abilities. It is also known as illusory superiority.

People often overestimate both their own predictive abilities and precision of information they have been given. In simply words, people think that they are smarter and have better information than they actually do.

There are two kinds of knowledge, primary (how much you know) and secondary(how well you know your limits). Studies show that regardless of ones' primary knowledge, secondary knowledge is almost always overestimated. People tend to overestimate the probability that they are right, and thus they are surprised more often than they think. Great investors like Warren Buffett often stresses that he stays within his circle of confidence, and only invest in what he knows. Average investors on the other hand, assign too narrow of a confidence intervals for their prediction and underestimate the downside risk. This also leads to overconfidence of their investment thesis and not enough diversification.

Not only dos investors make this mistake...

A Sad Example:

Before the shuttle exploded on its twenty-fifth mission, NASA's official launch risk estimate was 1 catastrophic failure in 100,000 launches (Feynman, 1988, February). This risk estimate is roughly equivalent to launching the shuttle once per day and expecting to see only one accident in three centuries.

However...

APOLLO 1 - JAN. 27, 1967

A flash fire erupts aboard the Apollo 1 during a routine launch-pad test, killing the three astronauts aboard.

APOLLO 13 - April 13, 1970

Four-fifths of the way to the moon, Apollo 13 is crippled when a tank containing liquid oxygen bursts. The three astronauts on board survive by moving into the lunar module until they are able to fly the main vessel safely back to earth.

CHALLENGER - JAN. 28, 1986

The space shuttle Challenger explodes over Cape Canaveral, Florida, just seconds after liftoff. Seven crew members, including beloved Teacher-In-Space Christa McAuliffe, are killed and the manned space program is dealt a nearly mortal blow. Five months later, the cause was made public: Two of the shuttle's O-rings had failed during launch.

COLUMBIA - FEB. 1, 2003

The Columbia shuttle, which had a wing damaged during launch, breaks apart in the Texas skies during re-entry, killing seven astronauts and raining debris over Texas and Louisiana. Investigators determined its left wing was gashed by fuel-tank foam insulation during liftoff, allowing fiery gases to penetrate the shuttle.

WALLOPS ISLAND - FRIDAY, AUG. 22, 2008

NASA destroys an unmanned experimental rocket launched from Wallops Island, Virginia, carrying a pair of research satellites after it veers off course. Officials said the rocket - a prototype made by Alliant Techsystems Inc., or ATK - was destroyed by remote control 27 seconds into the pre-dawn flight. It was between 11,000 feet and 12,000 feet high when it exploded. Officials said they do not know why it veered off course. It was destroyed to avoid endangering the public.

Source: Telegraph UK

Illusion of Control:

People behave as if their personal involvement can influence the outcome of a chance event.

Langer (1975) found that active involvement all lead to inflated confidence. People are more likely to behave as if they could exercise control in a chance situation where "skill cues" were present. For example, people like to pick their own numbers when buying lotteries although the probabilities are all the same.

Illusion of control accompanied with overconfidence result in excessive trading. It is no secret that overactive trading is hazardous to performance.

Barber and Odean (2000), after studying over 66,465 trading accounts that after taking trading costs into account found that the average return of investors is well below the return of standard benchmarks, largely due to transaction costs. From 1991 to 1996, those that trade most earn an annual return of 11.4 percent while the market returns 17.9 percent. The average household during the meantime earns 16.4 percent.

Source: Berkeley

The researchers have also found that men are more overconfident than women thus trade more and underperform. On average, men trade 45% more than women and underperform women by 0.93% a year. The same attribution extends to professional analysts.

Overconfident Analyst:

A number of researchers (Abarbanell, 1991; Brown, Foster, and Noreen, 1985; Stickel, 1990) found that financial analysts on average are too optimistic. Stocks that they are covering and their forecasts of earnings are systematically higher than the actual earnings announced ex post. They tend to give more buy ratings than sells. This can also be because of their career concerns.

It is most evident among the most popular stocks. 85% of the analysts have a buy recommendation for Apple (NASDAQ:AAPL) while only 15% have a hold or sell recommendation. Moreover, as Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) has surpassed Apple at the open today and 45 out of the 48 analysts recommend a buy rating. Analyst ratings are usually negatively correlated to stock performance, I will talk more about this and how to exploit it in the following part of the series.

Takeaway:

I believe that studying our human nature and other investors' biases can help us make better investment decisions and avoid pitfalls in our perceptions. In the world of investing, the biggest enemy is likely to be ourselves. I would like to leave you with the quote from Ben Graham.

The investor's chief problem-and even his worst enemy-is likely to be himself. - Ben Graham

Finally, congratulations for making it to the end! If you like what you are seeing, please click the follow button, so you don't miss the next part of the series. Hopefully, the series is as entertaining as the Seeking Alpha community.

Disclosure: I/we 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.