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Behavioral Biases: What Makes Your Brain Trick? By Brian Puckett, CFP®, CPA/PFS, Attorney at Law

In last month’s blog, we discussed the deep-seated “fight or flight” instincts that that trick us into making significant money-management mistakes. Now let’s take a look at a half-dozen of the behavioral biases that arise from our wiring, and how they can sabotage even the best-laid investment plans.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens to you when you see a market movement afoot and rush to join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a “next big thing” stock. Or it may be fleeing a perceived risk, such as a country in economic turmoil. Either way, as we covered in “Ignoring the Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses.

Behavioral Bias #2: Recency

Your long-term plans are also at risk when you succumb to the tendency to give undue weight to recent information. In “What Drives Market Returns?” we learned that stocks have historically delivered premium returns over bonds. Whenever stock markets dip downward, though, we typically see recency bias at play, as droves of investors sell their stocks to seek “safe harbors.” In a roaring bull market, they reverse course and buy.

Behavioral Bias #3: Confirmation Bias

Confirmation bias is the tendency to favor evidence that supports our beliefs over evidence that contradicts them. We watch news shows that support our belief structure; we skip over those that might challenge us to change our views. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous decision-making approach we described in “The Essence of Evidence-Based Investing” is so critical. Without it, our minds will rig the game to support our beliefs—even when they lead to bad investment outcomes.

Behavioral Bias #4: Overconfidence

Garrison Keillor made overconfidence famous in his description of Lake Wobegon, “where all the women are strong, all the men are good looking, and all the children are above-average.” Keillor’s gentle jab actually reflects reams of data indicating that most people (especially men) believe that their acumen is above average. On a homespun radio show, overconfidence is quaint. In investing, it’s dangerous. The truth is that investors cannot expect to consistently outsmart the collective wisdom of the market, especially after the costs involved.

Behavioral Bias #5: Loss Aversion

Research has shown that we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. As Jason Zweig, author of Your Money and Your Brain, states, “Doing anything—or even thinking about doing anything—that could lead to an inescapable loss is extremely painful.”

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets—or even when a correction “seems” overdue. The evidence clearly demonstrates that you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks after they have fallen & while they are “cheap.” And yet, even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we resist selling until it’s at least back to what we paid. In a data-driven strategy (and life in general), the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of losers (or even winners) that no longer suit your portfolio’s purposes, an otherwise solid investment strategy can be undermined.

There are many more behavioral biases, as detailed in Zweig’s and others’ books on behavioral finance. We recommend that you take the time to learn more. Understanding our bias can help us become more confident investors—and they’re likely to enhance other aspects of your life as well.

For more, please visit http://www.alignmywealth.com/blog

Brian Puckett | JD, CPA, PFS, CFP®
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THE ESSENCE OF EVIDENCE-BASED INVESTING Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

In our most recent blog, “What Drives Market Returns?” we explored how markets deliver wealth to those who invest their financial capital in human enterprise. But, as with any risky venture, there are no guarantees that you’ll earn the returns you’re aiming for, or even recover your investment.
This leads us to why we so strongly favor what is known as evidence-based investing. Grounding your strategy in a rational methodology helps you best determine your financial goals—and it helps you stay on course toward those goals even when your emotions threaten to take over.
The origins of evidence-based investing stretch back to at least the 1950s, when scholars began studying financial markets to answer key questions such as:

• What drives returns? Which return-yielding factors appear to persist over time, around the world and across a range of market conditions?
• How do the return drivers work? Once identified, can we explain why particular return-yielding factors exist, and exactly how they work?

Meanwhile, fund companies and other financial professionals seek to translate this academic inquiry into successful investments. Their job: to capture the theoretical return premium in the real world, and to preserve it even after implementation and trading costs are factored in.

In any discipline—from finance to medicine to quantum physics—it’s academia’s job to discover the possibilities; and it’s the professionals’ job to figure out what to do with the understanding. It’s important to maintain the distinct roles of financial scholar and financial professional in order to ensure that each is doing what we they do best in their field.

In academia, rigorous research typically demands:

A Disinterested Outlook. Rather than beginning with a point to prove and then figuring out how to sell it, academic inquiry is conducted with no agenda other than to explore intriguing phenomena and report the results of the exploration.

Robust Data Analysis. The analysis should be free from weaknesses such as:
• Data that is too short-term, too small of a sampling to be significant, or otherwise tainted.
• “Survivorship bias,” in which the returns from funds that were closed during the study (usually because of poor performance) are omitted from the results.
• Apple-to-orange comparisons, such as using the wrong benchmark to evaluate a strategy’s “success” or “failure.”
• Insufficient use of advanced mathematics like multi-factor regression, which helps identify valuable factors within a confusing, noisy mix of possibilities.

Repeatability and Reproducibility. Academic research requires results to be repeatable and reproducible by the author and others, across multiple, comparable environments. This strengthens the reliability of the results and helps ensure they weren’t based on luck.

Peer Review. Last but not least, scholars must publish their detailed results and methodology, typically within an academic journal, so that their peers can review and their work. As is the case in any healthy scholarly environment, those contributing to the lively inquiry about what drives market returns are rarely of one mind.

So, it’s wise to step away from the popular financial media and take a look at academic research about the way investing really works. Wall Street’s message tends to be “invest with us and we’ll make you rich,” in a very short time horizon. Wall Street’s profit motives also affect which research it shows clients, because the primary purpose of Wall Street research is to sell you products.

Our evidenced-based investment philosophy comes from the academic world and is based on more than 87 years of investment results, not on what happened last year or even over the past few investment cycles. Academic researchers are motivated by truth – not what sells product. Academics strive to win the Nobel Prize – not the “top producer of the year award”.

In short, we firmly believe that an evidence-based approach to investing offers the best opportunity to advance and apply well-supported findings and strengthen your ability to build and preserve your wealth.

Financial Gurus and Other Unicorns Part II

By Brian Puckett

Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking. Among the earliest such studies is Michael Jensen’s 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” He concluded that there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”

A more recent landmark study is Eugene Fama’s and Kenneth French’s “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” from 2009. Fama and French demonstrated that “the high costs of active management show up intact as lower returns to investors.”

In the decades between those two studies, as 100 similar studies, published by a who’s-who of academic luminaries, have echoed the findings of Jensen, Fama and French. In 2011, the Netherlands Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: “Selecting active funds in advance that will achieve outperformance after deduction of costs is … exceptionally difficult.”

Can hedge fund managers and similar experts fare better than mutual fund managers? The evidence suggests not. For example, a March 2014 Barron’s column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year-end, and nearly half of the hedge funds available five years prior were no longer available (presumably due to poor performance).

So far, we’ve been assessing some of the reasons it’s hard to “beat” the market. The good news is that there is a simple way to let the market do what it does best on your behalf. In our next few blogs, we’ll begin to explain how.

For more, please visit http://www.alignmywealth.com/blog