Commentary | Apr 06, 2021

We Have Met the Enemy and It Is Us


Behavioural finance is the study of the influence of psychology on the behaviour of investors. Its central theme is that investors are not always rational, have limits to their self-control, and are influenced by cognitive biases. People harbour a multitude of self-defeating behaviours that lead to self-defeating results.

In “The Laws of Wealth: Psychology and the Secret to Investing Success”, author Daniel Crosby states: “The fact that people are fallible is your biggest enduring advantage in the accumulation of greater wealth. The fact that you are just as fallible is the biggest impediment to that very same goal.”

Confirmation Bias: Letting the Tail Wag the Dog

Confirmation bias is the tendency of people to pay close attention to information that confirms their beliefs and ignore information that contradicts it.

Most of us have a really bad habit of only paying attention to information that agrees with our existing beliefs. Our natural tendency is to listen to people who agree with us because it feels good to hear our opinions reflected to us. We also tend to let the proverbial tail wag the dog – to draw conclusions before objectively weighing the facts. We first construct hypotheses, and then subsequently look for information that supports them.

Even some of the greatest investors have fallen prey to the confirmation bias trap. In December 2012, Bill Ackman, Chief Investment Officer of Pershing Square, launched a crusade against Herbalife, a nutritional supplements company, referring to the company as a pyramid scheme and stating that its stock was worthless. After taking a $1 billion short position in Herbalife, he continued to seek supporting evidence for his original hypothesis from Herbalife customers who had poor experiences with the company. Activist investor Carl Icahn, who had an opposing view, acquired a 26% ownership stake in the company. The epic battle that ensued between two of Wall Street’s biggest titans resulted in a major loss for Ackman. Had Ackman attempted to find potential flaws in his thesis by seeking out customers who had positive Herbalife experiences, he might have either avoided or mitigated the losses which his fund suffered.

Loss Aversion/Disposition Effect: The Pain of Losses is (Myopically) Larger Than the Pleasure of Gains

Loss aversion does not describe the tendency of people to try and avoid losses, which is completely rational. Rather, it refers to having an economically unbalanced desire to avoid losses at the expense of foregoing commensurate or greater gains, which can cause them to win battles yet lose wars.

Loss aversion can cause investors to refrain from selling losing positions in the hope of making their money back, thereby allowing run of the mill losses to metastasise into “there goes my house” losses. Loss aversion can also lead to significant opportunity costs, as money gets “trapped” in underperforming investments at the expense of foregoing better opportunities.

Closely related to loss aversion is the disposition effect, which refers to a cognitive bias that causes investors to sell winning positions prematurely and irrationally stick with losing positions. When a position is rising, we get anxious to lock in our gains and sell prematurely. At the same time, people are often too slow to cut their losses on holdings which are losing money and hold on to them in the hopes that they will recover. These behaviours tend to diminish gains and exaggerate losses, thereby leading to poor overall performance.

Fear of Missing Out: There’s Nothing More Annoying Than Watching Your Neighbour Get Rich

Fear of Missing Out (FOMO) refers to feelings of anxiety or insecurity over the possibility of missing out on an event or opportunity.
What is most interesting is that FOMO is an emotional reaction that pushes us to trade or invest in a less disciplined way. Rather than buy stocks when they offer the most attractive risk-to-return ratio, investors are driven to buy them to an even greater degree the less attractive they look technically. Our fear of missing out becomes greater the more the market continues to act in an irrational way.

FOMO is frustrating because it occurs when the market is doing the unexpected and we are sticking to a solid plan. From 1996 to 2000, the NASDAQ stock index exploded from 1,058 to 4,131 points. Many of these technology stocks had little or no earnings yet still commanded steep prices. Investors feared that if they didn't get in now they would miss out. Millionaires were minted overnight until it all went wrong. The dotcom bubble burst, and trillions of dollars of investor wealth vanished as the NASDAQ plunged to under 2,000 points by the end of 2001. Few did their due diligence on these hot tech stocks to make sure they were the best long-term investments for their personal portfolio and goals. It took many years for the average investor to recover.

In his characteristically folksy yet caustic manner, Buffet used the following analogy to illustrate the absurdity of FOMO:
“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem: They are dancing in a room in which the clocks have no hands.”

The Bandwagon Effect: Making Sheep Look Like Independent Thinkers

The bandwagon effect describes the tendency of investors to gain comfort doing something simply because many other people are doing it. The tendency of people to prefer doing ill-advised things that others are doing rather than act rationally in isolation is best summarized by John Maynard Keynes:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Whereas using the performance of others as a reference point for measuring your results mitigates the risk of underperforming your peers, it can expose you to severe losses. The widespread abandonment of reason and rationality associated with a herd mentality has historically resulted in speculative bubbles in which the crowd joins hands and runs off the cliff together.

Buffett tells a story about the oil prospector who dies and is in a large crowd of other oil prospectors who are all waiting at the gates of heaven. Suddenly, the crowd disperses. Saint Peter asks the oil prospector why the crowd dispersed. The oil prospector said it was simple: “I shouted, ‘Oil discovered in hell.’” Saint Peter asks the oil prospector if he would like to be let into heaven. After thinking for a while, the oil prospector says, “I think I’ll go and join my colleagues as there may be some truth in that rumour after all.”

Anchoring/Framing Bias: Making a $20 Burger Seems Like a Steal

Anchoring bias is the tendency to rely too heavily on, or anchor to, a particular reference point or piece of information when making a decision.

New York eatery Serendipity 3 made headlines for offering a $69 hot dog, which, according to the Guinness Book of World Records, was the most expensive wiener in history. The resulting media hype drew masses of customers to the eatery. Despite the crowds, sales of the luxury hot dog were not particularly strong. However, sales of their pricey $17.95 cheeseburgers soared. People opened their wallets because a burger that costs nearly $20 seems reasonable at a place that charges $69 for a hot dog.

In the world of investing, recent stock prices are a powerful anchor that can bias people’s decisions. People often base their investment decisions on where current prices stand relative to their histories. Unfortunately, where a stock’s price has been in the past often offers little information on how it will perform going forward. A stock’s historical high price can make its current price look cheap, regardless of the company’s actual value. Interpreting past glories as harbingers of things to come led to wrong-way positions in a multitude of “fallen angels”. There can be little doubt that Blackberry or Nortel’s high-water marks proved ineffective in predicting their fates.

Inertia Bias: Do Nothing and Hope Nothing Happens

The inertia bias describes people’s aversion to change. Investors can become complacent, deluding themselves into believing that existing conditions will continue indefinitely. This mindset renders them as defenseless a proverbial deer in the headlights when circumstances change, exposing them to avoidable losses.

The status quo bias is currently evident on a grand scale. Investors have enjoyed a bull market in bonds for the past 25 to 30 years, and many portfolios have not adapted to the distinct possibility that rates are likely to rise (and perhaps significantly). Many people have kept the bond portions of their portfolio static—even though it would be prudent to shorten their durations and/or re-allocate some of those dollars to other assets.

Evidence: Where the Rubber Meets the (Rough) Road

Since 1984, investment research firm Dalbar has been publishing its annual report: "Quantitative Analysis of Investor Behavior" (QAIB). The study aims to demonstrate how emotions and cognitive biases cause investors to act imprudently. The QAIB reports clearly show that people are often their own worst enemies when it comes to investing.

In the 10 years ending December 2019, the average U.S. equity fund had an annualized return of 13.6, while the average investor in these funds reaped an annualized return of 11.1%. The 2.5% annualized difference is primarily attributable to emotionally driven decisions to invest and divest and proves the adage that the public always buys the most at the top and buys the least at the bottom. This behavioural pitfall is magnified by the mechanics of compounding. For a $1 million investment, the 2.5% annualized underperformance reduces your total gains by a stunning $407,837. Clearly, emotions and compounding mix about as well as oil and water!

What About the Experts?

An interesting question is whether professional fund managers, who are typically considered the “smart” money, also make behavioural mistakes. This very topic is addressed in the 2019 research paper “Are Professional Investors Prone to Behavioural Biases? Evidence from Mutual Fund Managers”. After analyzing mutual fund data covering the period from 2006 through 2018, the author’s findings “suggest that professional investors suffer from behavioural biases, that their market outlook affects their risk taking and asset allocation, and that fund managers’ optimism is detrimental to fund investors.”

The notion that professional fund managers make many of the same behavioural errors should not come as a surprise, given that they too are human.

We Are Content Betting Against Ourselves and Embracing the Machine

If we’re going to be smart humans, we must learn to be humble in situations where our intuitive judgement simply is not as good as rules-based processes based on statistical analysis. We believe that data, math, and a logical decision-making process leads to superior results over the long-term.

The Outcome funds are completely devoid of human intuition, instinct, or judgement. We follow a 100% rules-based, machine-learning driven approach that is rooted solely in quantifiable evidence. Our eschewal of the Ouija board for the data room has enabled our strategies to deliver superior risk adjusted returns, which we believe will continue to be the case over the long-term.