Wednesday, June 25, 2008

Section V- Why you will probably make bad decisions; a brief note on behavioral finance

What would you estimate the average weight, in tons, of an adult male sperm whale to be? Go ahead, try and answer.

How about giving a high and low estimate, in miles, of the distance between here and the moon?

If your answers to both of those questions were narrow ranges, like 5 to 10 tons for question one or 100,000 to 150,000 miles for question two you probably are susceptible to overconfidence bias. Psychological biases will play the single most important role in the success of your personal investment program. Fortunately, most biases are the result of simple ignorance and can be solved through education (there are also intense emotional biases that I won't cover here). In case you're wondering, the answer is 20 tons and 240,000 miles. Those of you that answered with wide ranges probably are less likely to develop overconfidence bias.

Individuals demonstrating overconfidence bias will usually have concentrated portfolios as they believe they possess superior analytical abilities and selection skills. They will also tend to ignore the potential downsides as they believe it is unlikely an investment they select will lose value. Luckily, the overconfidence bias is cognitive, meaning it is treatable with a little education.

Advice: Be upfront and honest about your capabilities and get an outside opinion. If you have been managing your own money for awhile, be honest about your performance. This is why Financial Advisors are so helpful, they act as a filter for your dumb ideas and biases.

Here's another question:

What is the probability that George (a shy, introverted man) belongs to Group A (stamp collectors) rather than Group B (BMW Drivers)?

You might conclude that George's shyness is more typical of stamp collectors than BMW drivers when statistics show there are more BMW drivers than Stamp collectors.

This is called Representative Bias. People have a tendency to group situations into familiar buckets, even when statistics disagree. Here's how it might play out in your mind as you are investing. Say you're looking for a great long-term investment and your friend informs you of a hot pharmaceutical stock that will have an IPO and explains the kind of drug the company manufactures. This sounds good to you so you go ahead and invest. The problem? You incorrectly assume that owning a company that might potentially have an IPO is a good long-term investment. Statistically speaking, it is more likely you will lose money over the next few years. You have to actually ask yourself if you've made an incorrect assessment of the situation. Again, your best friend is information. Always study the behavior of a potential investment and approach the decision logically. Understand where the opportunity falls.

One more, try this question:

Say you're outside washing your new car when your neighbor comes by. He notices your new car and immediately says, "Wow, did you know they are giving away free DVD players in model XYZ?" You were not aware of this when you made your purchase. What do you do?

If you run inside and begin to do research but then stop, for fear of what you might learn, you may suffer from cognitive dissonance (buyers remorse). This bias causes all sorts of problems for investors. CD happens anytime someone has to make a selection. While the offering we select has obvious downsides, the one we didn't select has redeeming qualities. Investors dealing with CD often won't sell a poor performing holding only because they do not want to confirm they made a bad decision. Or they might continue to contribute money to a poor performing holding to simply confirm their earlier decision that it was a great investment. It also leads to herd behavior and following the press.

Cognitive dissonance is such a tricky bias to deal with. The best thing to do here is to set ground rules ahead of time, have a plan and maintain objectivity. In the case of selling a losing investment, your policy might be that it's O.K. to hold on to a losing investment for 18 months (or whatever timeframe) and then re-evaluate. Adhering to a policy helps to mitigate the potential dissonance one might feel as the result of a previous decision.

Now, I just shared three basic, albeit pervasive, investment biases. The questions above come from a great book by Michael Pompian entitled "Behavioral Finance and Wealth Management." The point here is that as an investor, you are aware that you most likely are making a biased decision. If you find yourself making decisions without consulting disinterested third parties or gathering independent information, you may want to take a step back and attempt to identify your logic. At the same time, try and understand when an exception to the prevailing data may be warranted and if you are then justified. But for heaven's sake, don't listen to somebody's hot tip at the family reunion!

Next week I'll be back to blogging about current economic events. Stay tuned.