"Success in investing doesn't correlate with IQ ... what you need is the temperament to control the urges that get other people into trouble in investing." -- Warren Buffett
Behavioral finance is the field of study that recognizes that there is a psychological element to an investor's decision-making. This field studies how psychology and emotion lead to bad investment decisions and poor performance results. In this article I will give an overview of some of these ideas, and I will show how the discipline of dividend growth investing helps to overcome many of the pitfalls covered by this field. I will only mention a few of the concepts of behavioral finance. For more detailed information, I suggest you read "The Little Book of Behavioral Investing: How not to be your own worst enemy" by James Montier (I relied on Bruce Grantier's review of Montier's work to help me write this article).
By nature, humans rely at least as much on emotion as on reason. This has served our species very well in many aspects of life (and survival). But when it comes to investing; bias, emotion and overconfidence can get in the way of good returns. Overconfidence, herd mentality, loss aversion and self-attribution can cause us to buy or sell the wrong investments at the wrong time (or the right investments at the wrong time). Not all of these attributes will be seen in every investor. In fact, some of them work opposite to each other. But each, individually, or as a group, leads us to make poor decisions.
Overconfidence: People believe in their own abilities far more than they should, especially when it comes to investing. This is especially true for men, more so then women, which explains why many studies show that women make better investors. Over confident investors misjudge their ability to evaluate stocks. They make poor decisions, and then rely on their own poor stock picking abilities to fix the problem. This leads to poor stock choices, excessive turnover, increased transaction costs, and underperformance. Over confidence can apply to investment professionals as well as non-professionals. Many professionals charge very high fees for advice or to manage your money, even though they usually fail to demonstrate returns that match the market. They charge what they believe they are worth, rather then what they actually are worth.
Complicating the investor's over confidence is the tendency to accumulate more and more information to try to determine what is and is not a good investment. The more information accumulated, the more confident the investor becomes, even if the extra information has done nothing to actually educate them more. Another problem is that the investor often has a tendency to believe the information that supports the conclusion they have already made, and ignore any information that may refute it. This just tends to make their results even worse.
Self-attribution: When an investor has a good outcome he credits himself for making good decisions. When the investor has a bad outcome he blames the market, or the economy, or a bad CEO, or just bad luck. Whatever the case, the investor gives himself too much credit or not enough blame. This allows him to stay over confident, and continue to make bad decisions.
Loss aversion: People typically give more weight to losses than to corresponding gains. They feel the pain of a loss more than the joy of a profit. This can be a problem after bear markets. The market drops so the investor sells (in itself a problem, selling low). Then, because the pain of that loss is fresh, and outweighs any memory of previous gains, the investor stays out of the market far longer than they should, waiting until a new bull market is well underway before they get back in (buying high).
Herding: Humans are social creatures, and it is in our nature to go along with the crowd. We tend to want to do what everybody else is doing, leading us to buy the same hot stocks that everyone else is buying. You see a hot stock rising, and you hear your friends talking about how they own it, and you want to get in on it with them. Unfortunately by the time you buy it the stock is near its high and you get in just in time to ride it down as it falls. Buying the stock that nobody is talking about, or that is out of favor, is often a better strategy, but due to human psychology it is much harder to do
These are tendencies which we, as investors, must constantly fight against. The way I do this is by using dividend growth investing (DGI). One of the most appealing things about dividend growth investing is that it is a discipline. There is a plan. There are criteria for what stocks to buy, there are criteria for how to manage your portfolio, and there is a plan for when to sell. Most if not all emotion is taken out of the decision making, and therefore many of the psychological and emotional pitfalls discussed in behavioral investing are removed.
Montier summarizes human biases into the "Seven Sins" of money management. After each sin I show how DGI investing helps to counter act the poor tendency.
1. Enormous evidence shows investors are hopeless at forecasting, yet it may be at the heart of their investment process. As a dividend growth investor I don't forecast. I look at the past dividend history of a company, including the past growth rate and the years of uninterrupted payments, and buy stocks with stellar dividend histories. Then I follow the stock to make sure it continues to act in a way that satisfies my requirements. These requirements are known, even before I buy the stock. All I have to do is follow them. In this way I don't have to worry about whether or not my emotions are affecting my decisions.
2. Investors are obsessed with information, yet more information doesn't lead to better decisions, just overconfidence. For me I only look at the company's past earnings, past dividend record, S&P ranking and FAST graph to decide whether or not to buy. Once I own the stock I will only sell the stock if the company cuts or freezes the dividend. In this way I keep from looking at too much information and being led astray by meaningless stats that only make me think I know more, without actually knowing anything else that is important.
3. Meetings with company management are overrated; management themselves are likely highly biased. I don't listen to anything an analyst or a company spokesperson says, unless it is about the dividend. All else is noise to me. Even talk about earnings is not that important to me. I just want to hear that the dividend is still going up at a rate that satisfies me.
4. Investors typically think they can outsmart everyone else. I know I can't outsmart all the financial experts. Instead I go the opposite way and try to keep it as simple as possible. I purposefully limit the amount of information I follow because I'm not smart enough to follow what all the analysts do. By keeping it to the basics I believe my results will be at least as good as the "experts".
5. Investors are (increasingly) obsessed with short-term time horizons. This is one of the most wonderful things about being a dividend growth investor. It is a long term investing discipline. I don't care about short-term gains. My time horizon is very long term (20+ years). Don't get me wrong, I like seeing my portfolio value increase just as much as anybody, but even if it isn't going up, or if the value is even falling, as long as my dividend income keeps growing month after month, year after year, I'll be happy. I know that eventually, if my companies keep paying increasing dividends, the stock prices will eventually rise as well.
6. People like good stories and often enhance them to suit their own biases, while ignoring the boring facts. The mind's default tendency is to believe; innate skepticism is rare, yet advantageous in investing. People tell a lot of stories on Wall Street; stories about how great a company will do next year; stories about what great returns they will get for you if you invest your money with them; stories about how interest rates will rise or fall next year, etc. As a dividend growth investor I have the luxury of ignoring all these stories. A dividend that appears in your account is a fact. Yes, earnings can be somewhat manipulated, but a dividend that continues to rise year after year is a story that everybody can see and believe.
Summary Dividend growth investing, by setting out a plan, by setting out specific criteria for when stocks will be bought or sold, and by setting out specific guidelines for what to do when those criteria are not met, allows the investor to take almost all emotion and psychology out of their investment decisions. By doing so DGI helps the investor to avoid the mistakes discussed in "The Little Book of Behavioral Investing" and helps them to improve their investing results over the long term. As for me, it also helps me sleep very well at night.
Thank you for reading my article. I welcome your comments.
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.