Attitude is a little thing that makes a big difference. -Sir Winston Churchill
Greed and fear are the two dominant forces that move markets on a daily basis. When stocks are going up, an investor might feel greedy and rush to buy more shares at increasing values, driven by greed to make more and more profits. When stocks are in a general decline, investors tend to sell out of fear that their investment “will go to $0” and they’ll lose everything. Interestingly, these short-term responses to the market force it to overreact, as more buying just pushes up prices to unreasonable and unsustainable levels and more selling drives prices further down to deeply discounted levels. Thus, greedy or fearful investors are buying stocks at highly marked up prices or selling at deep discounts to the true intrinsic values of the underlying businesses. The investor descends into a pattern of buying high and selling low.
Over the short-term, stock prices respond to these widely erratic emotional states and rapidly changing reactions of greed and fear. However, over the long-term, stock prices are determined by and accurately reflect the operating results of the underlying businesses. Over the long term, stock prices correctly reflect the growth in corporate earnings of well managed firms and the not so well managed firms.
However, as investors we are all human and thus are “bequeathed” with both cognitive and emotional biases that, if unchecked or unrecognized, make it difficult for us to see the long-term opportunities among the daily, monthly, and quarterly market volatility.
Over the last couple of months, these Monthly Insights letters have defined and provided examples of how these biases may prevent long-term investors from reaching their long-term goals and objectives. For example, in February when we discussed the long-term exponential growth of the markets, we mentioned how humans think linearly and not exponentially, and therefore do not easily understand the full potential of staying in the market over the long-term (exponential growth bias). We also showed how a “present bias” drives would-be investors to spend money now rather than invest it in the present for long-term benefit.
In the March Monthly Insight letter, we discussed investor’s risk tolerance, risk capacity, and risk perception, along with four biases that may cause investors to have an inappropriate appetite toward risk and investing. Loss aversion is the perception that losing $20 feels twice as bad as finding $20 feels good. Recency bias leads us to believe that recent events are more relevant than events further in the past. Familiarity bias prevents an investor from properly diversifying a portfolio because the investor has personal attachment or specific knowledge about a small sector of the market. And availability bias reflects an emotional outcome an investor dreams up—it’s a function of whatever an investor just heard on the radio or saw on TV and is most available in their consciousness, whether based on fact or fiction.
In this final installment of our Market Insights series addressing cognitive and emotional investor biases, we wanted to look at four more common types of bias.
- Cognitive confirmation bias is a natural tendency for an investor to reject or accept only data that confirms existing beliefs, while ignoring data to the contrary. For example, international (non U.S.) stocks have a definite place in a well-diversified portfolio. Yet some investors refuse to hold international stocks, quoting data that shows international stocks being down over the last three years, while ignoring data that demonstrates longer trends to the contrary.
- Emotional endowment bias may manifest when an investor buys a stock and continues to seek confirming data to support his investment (confirmation bias). This can develop into an endowment bias that leads him to believe his mere ownership of the stock increases its value. For example, now that the investor bought a stock for $30, and nothing except his ownership of the stock has changed, he feels adamant he would not sell it for $30—but maybe he’d sell for $40. In a similar vein, many people inherit stocks and are unwilling to sell them because they value the asset more solely based on ownership.
- Cognitive hindsight bias affects all of us from time to time. Hindsight bias is the tendency for investors to see past events as having been more predictable than they actually were at the time they occurred. Investors with a hindsight bias also tend to believe that their predictions are more accurate than they really are. They look back and determine that the market crash was inevitable and wonder why they didn’t sell before the crash.
- Cognitive representative bias becomes evident when an investor uses small or inappropriate sample sizes to reach a conclusion. Mostly this happens when an investor studies short-term returns of one, three, or six months and either sells or buys investments based on this small sample size. For example, if small-cap value stocks have underperformed large-cap growth stocks over the last six months, the investor would sell the small-cap value fund and buy the large-cap growth fund, not understanding how this trade would affect the long-term return expectations of the portfolio.
We hope this discussion brings you clarity about your own investing mindset. If you see any of these biases affecting your attitude toward the markets, or if you want to further discuss your portfolio allocation, goals, or objectives, please give us a call. We are honored to be your financial advisor and value our friendship and professional relationship.