Avoiding Investor Pitfalls – Risk Aversion
Contributed by Doug Walters, Max Berkovich
This week I was asked, “What are the three greatest investor pitfalls?” Great question! My “evidence-based investing” mind had hoped there was some way to quantify this answer, but I could not find any research ranking pitfalls. So instead, I have combined our understanding of behavioral finance with our 40 years of experience working with private investors to call out three big pitfalls. We will spend the next three weeks unpacking each.
Some pitfalls have huge implications but are rare and therefore we have not considered them. An example would be someone putting all of their investing eggs in one basket. That is incredibly risky, but we rarely see it. Our focus is on actions that are more common and are often motivated unconsciously by inherent human behavioral biases. We categorize them as:
- Risk Aversion
- Fear of Missing Out (FOMO)
- Overconfidence
Risk aversion (and the related prospect theory) is believed to have been an important survival instinct in human evolution. In investing, it works against us. It turns out the negative feelings of loss are much more pronounced than a similar gain. For example, imagine the feeling of walking down the street and finding $1000 compared to the agony of the person who realized $1000 fell out of their pocket. The same phenomenon is present with gains and losses in a portfolio.
One study (Shiv et al., 2005) showed how this behavioral bias could impact logical decision-making. The setup of the study was simple. Give participants $1 to bet, then flip a coin. Heads – the dollar is lost. Tails – the $1 investment earns $1.50. This was repeated 20 times. This is a no-brainer. Logically, you should bet every time. But thanks to risk aversion, that did not happen. “Investors” not only did not bet every time, but the longer the experiment went on, the less they invested.
So how does this manifest itself as an investor pitfall? It is risk aversion that drives investors to want to exit or reduce risk following declines in their portfolios. Yet, a market decline would imply that, all else equal, investments are cheaper! So, instead of running for the hills, investors should be perhaps bargain shopping. Investors who can repress their natural bias for risk aversion have just avoided one of the most destructive investor pitfalls!
Retail Sales
It may not seem like a lot, but the 0.7% retail sales growth in August was a big surprise and sign of consumer resilience despite the pandemic.
Another week in the red for stocks, investors digested economic data and tax hike proposal(s) from Congress.
Consumer Report
Retail Sales gained 0.7% in August, which was a relief to investors as it declined in the previous month.
- Not only did the consumer spend a little more in August, but the U.S. Retail report numbers were revised upward for July.
- Consumer spending makes up roughly 70% of U.S. economic activity. Seeing a bounce back in that is a good sign for the economy.
- Experts give credit to back-to-school shopping and child tax credit payments for the boost.
- Retail sales are up over 15% from the same time last year.
- Follow through in September will be critical, with Christmas spending key to finishing the year strong.
Less is more
- The Consumer Price index (CPI), a widely followed inflation measure, increased by only 0.3% last month. This was less than projected.
- The less than expected inflation report allows the “transient inflation” camp to run a little longer.
- The year-over-year inflation number is still above 5%.
- Evidence that inflation is transient is expected to keep the Federal Reserve on the sidelines when it comes to tightening policy.
Compromising position
Funding the $3.5 Trillion spending plan is hitting snags as Democrats find it hard to reach consensus within their own party.
- So far, taxes on millionaires going up by 10%, and corporate tax rate by 4.5% are on the table.
- The joint committee on Taxation estimates $1 Trillion will be raised from higher taxes on high-income households and another $1 Trillion from corporations.
- Other estimated revenues include $700 Billion from a drug-pricing policy change and $120 Billion from stricter tax enforcement.
- For the record, $600 Billion is expected from faster economic growth.
- With so many variables and so many different special interest groups involved, the path to tax hikes is looking even less clear.
Judgement Day
While investors expected Apple Inc. (AAPL) to be in the news for their product unveiling event, it was instead for a ruling from a judge.
- Judge Rogers ruled this week that Apple violated antitrust law with its anti-steering policies in the App Store.
- This ruling will forbid Apple from preventing app developers from steering in-app purchasers to third-party payment options, bypassing Apple.
- The ruling will also impact Google (GOOG, GOOGL) as it utilizes the same practice.
- Also, the ruling did indicate that Apple is not a monopoly. A small victory for the company.
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