Behavior: Taming Your Investing Instincts
Doug Walters
Investors are often their own worst enemy due to ingrained biases. Decisions based on fear and euphoria are proven to damage long-term returns. Knowing where the pitfalls lie can help you avoid them.
Contributed by Doug Walters , David Lemire , Max Berkovich , Eh Ka Paw
We wrap up our series on our guiding principles today with the broad category of behavior. We touched on behavior in the first of our series when discussing patience, which we felt deserved its own spot amongst our principles. But behavior goes far beyond patience, and today, we provide an introduction.
A few years back, I gave a presentation entitled, Why Humans Make Bad Investors. Perhaps a surprising title for someone who has dedicated his professional life to the pursuit of high-quality investment performance. It is an acknowledgment that we, as humans, have navigated evolution thanks to many traits that served us well in prehistoric life but hinder us today in the financial world. Knowing those shortcomings allows us to overcome and take advantage of them simultaneously.
We don’t have the real estate here to cover the entirety of Behavioral Finance. There are entire textbooks on the subject. Instead, we provide a taste of how some of our ingrained biases can damage long-term returns if not kept in check.
Overconfidence Bias
93% of US drivers believe they are above-average drivers1. Yeah, we are overconfident! That trait has been shown to lead to excessive trading, unwarranted risk-taking, and underperformance. Any market timing behavior, like putting long-term investments on the sidelines in cash, is an investor saying, “I know what the future holds,” which is overconfidence. We recognize that the future is unknowable, and rather than futilely try to predict it, we focus on what we know to be true today.
Loss Aversion
The fear of losses has been shown to significantly outweigh the pleasure derived from gains. This bias can lead investors to hold onto losing investments for too long, hoping for a rebound, or prompt them to sell winning investments prematurely to secure quick gains. We make investment decisions based on the evidence in front of us today, not on the emotion of what happened yesterday.
Herd Mentality or FOMO
Human beings have an inherent tendency to follow the crowd, seeking safety in numbers. While this instinct may have been advantageous in our evolutionary past, in the financial world, it can contribute to market bubbles and crashes. We appreciate the opportunities that the excessive moves create for us patient investors.
Recency Bias
Recent events tend to have a disproportionate impact on decision-making. Take fixed income, for example. Investors are flocking to short-term treasuries after the significant declines in long-term bonds in 2022. However, evidence increasingly pointed to a bigger opportunity in 2023: long-term bonds. Investors who look past the recent moves and focus on the information in front of them today will have a better chance at success.
These examples are just the beginning and hopefully highlight the importance of taming ingrained behavior to investing success. Understanding these biases allows the informed investor to navigate their natural instincts and use them to their advantage.
And with that, we wrap up our series on our guiding principles. Links to the entire series can be found below.
- Guiding Overview: Unveiling the Evidence
- Patience: The Foundation of Investing Success
- Diversification: Winning Even if It Doesn’t Feel Like It
- Factors: Systematically Advantage Your Portfolio
- Rebalancing: It Pays to be Opportunistic
- Expenses: A Hidden Drag On Performance
- Taxes: How to Help Manage the Inevitable
- Behavior: Taming Your Investing Instincts
1. Svenson, Are We All Less Risky and More Skillful than our Fellow Drivers?, 1981
On a related note…
In the Teaser Rates video we released last week, we hit discuss the risk of chasing short-term rates with long-term funds. This trend is, in part, driven by behavioral biases. #recencybias #overconfidence #FOMO
Headline of the Week
The Fed’s Preferred Measure
The Consumer Price Index or CPI gets the bulk of the attention, but anyone reading the financial press knows that the Federal Reserve prefers to focus on a different measure: the Personal Consumption Expenditures (PCE) price index. We’ll spare you the minutia as this month’s PCE, excluding the bothersome food and energy effects, posted a slight increase, largely in line with expectations. While the year’s inflation remains high, the underlying trends point to inflation heading towards the Fed’s 2% target. One metric getting more attention of late is a look at the most recent six-month trend (and annualizing it), which shows inflation tracking towards a 1.9% annual rate.
Whether the inflation news adds fuel to the official start of the “Santa Clause Rally” remains an open question. Santa has delivered quite nicely thus far. Markets will likely continue to aggressively pencil in more rate cuts for 2024, but we shall see how hard (if at all) the Fed pushes back.
The Week Ahead
With 2023 coming to an end, the holiday-shortened weeks have very little on the calendar in the US and Europe, so it shouldn’t be surprising that Japan and China will likely drive headlines. Have no fear. It doesn’t stay quiet for too long as we kick off the new year with the Institute of Supply Management’s Purchasing Managers Index, minutes from the December Federal Reserve meeting, and a jobs report.
Looking East
Japan’s crummy year for the Yen is coming to an end. The currency is down around 8% versus the dollar.
- Continuing the negative rate policy was supposed to be unsustainable, but here we are!
- The damage to the Yen would have been even worse had the rest of the developed world not entered a rate-cut narrative.
- Markets imply an 80% probability that the Bank of Japan will finally exit its negative rates policy in April.
- That brings us to Japan’s central bank, which will release its summary of opinions (like the Fed’s meeting minutes) next week.
- Any morsel on what will drive Governor Ueda to make a move will be magnified next week in liquidity-constrained markets.
Liquidity Warning
With markets worldwide pausing the holiday and investors and traders extending their holidays, market liquidity dries up.
- This is a warning from XM Research to currency traders, but it applies to all investment markets: “When liquidity is low, financial markets can move sharply without any real news. And if there are news headlines, their market impact could be greater than usual. In other words, low liquidity conditions can amplify volatility, especially if there is a news catalyst.“
- Monday will be a public holiday in much of the world, so markets are closed. The same goes for the Monday after New Year.
Cheers!
To those celebrating… we wish you a Merry Christmas, a Blessed Kwanzaa, and a Joyous Festivus! And, of course, we at Strategic wish you nothing but health, wealth, and copious blessings in the New Year!
Happy New Year!
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