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Frank van Lerven CFP®

Ten Key Guidelines For Success In Investing

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Investors and their Decisions 7 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 7th and last one, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process and if so, what the practical consequences and applications are. This is the third article addressing managing these other factors (biases). This is the last article the author writes for OB Golf & Leisure Magazine. He thanks the editors for enabling him to share perspectives and ideas about personal finance with their readership and wishes the readers success on their paths of investing.

Ten Key Guidelines For Success In Investing

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DATA INVESTORS NEED TO PUT IN THEIR “COMPUTER”

In my previous 6 articles, I have tried to give answers to the startling fact that investors underperform the markets with several percentage points p.a. Aiming to explain this worrying fact, I introduced readers to the perspectives of Behavioural Finance, which suggests that people (investors) are prone to biases in their decision making progress- both cognitive and emotional biases.

For perspectives about possible remedies, I introduced readers to the workings of our brains, as put forward by Daniel Kahneman (1). I applied Kahneman’s concept of the fast and slow part of our brains to the investor making process and suggested investors use the slow part of their brain as a remedy against bias-prone investment decision making. I then discussed how a theory, successfully used in elite sport, also can be applied to investors in their decision making process: the theory of Dr Steve Peters (2).

I specifically addressed how investors can manage their “Inner Chimp”. In this concluding article to the series, I will discuss one more action investors could take to promote the making of sound investment decisions. This argument still follows the ideas of Dr. Steve Peters: to put “sound data” in the Computer part of our brain.

Summarizing Dr. Peter’s perspective about the functioning of our brain, simply put (3), there are three mechanisms with different characteristics working in our brain:

  • The Chimp which is emotive and irrational;
  • The Human which has self-control;
  • The Computer which thinks and acts automatically, using programmed thoughts.

Key is the interphase between these 3 parts. Particularly challenging is that these three parts react to what comes to us with different speeds. As I mentioned, in a previous article (again, according to Dr.Peters’ theory), the Chimp in our brain reacts 5 times faster than the Human (4).

According to Dr. Peters’ theory, the Computer has, in fact, the fastest speed of all three: 20 times faster than the Human and 4 times faster than the Chimp. So, it is essential that this Computer contains “sound data”. Naturally, this raises the question- what qualifies as “sound data”?

Readers when googling “investment wisdoms” will find several interesting notions about investing. These are often contradictory and more worryingly, either directly or indirectly promote the idea that amateur investors can outperform the market. So, they do not qualify for the “sound data” I am recommending. This author’s 10 suggestions about “sound data” takes to some extent a leaf of John Bogle’s 10 lessons (5), but takes a very different perspective on the role of advisers. Note: John Bogle is the founder of the Vanguard Group.

The critical 10 Key Data investors need to store in their Computer are:

1. INVESTING AND SPECULATING ARE DIFFERENT ACTIVITIES
When investing you aim for returns over the long term (minimal 5 yrs plus), by participating in the long term returns capital markets offer. When speculating you aim for returns in a day, week or month, aiming to profit from specific opportunities. These are both legitimate activities, but different, and need to be distinguished from each other.

2. MARKETS ARE THERE TO PARTICIPATE IN, NOT TO BEAT THEIR RETURNS
Trying to beat the market, or trying to find managers who do, is not the purpose of investing. This is a “losing game” anyway (6). Investors invest to meet personal goals and when materializing returns (net of costs) close to market returns they do great.

3. ASSET ALLOCATION IS THE KEY DRIVER
Asset allocation (between asset classes such as stocks, bonds and alternative investments) is key and the driver of performance. Decide on major adjustments, not because of market conditions, but because of changes in your investment goals.

4. RETURN AND RISK GO HAND IN HAND
This is stating the obvious…or is it? Are you familiar with: “getting maximum returns with minimal risk”? This is a mythical notion that does not equate to “sound data”. There is no escaping this fact: risk and return go hand-in-hand.

5. TRENDS COME AND GO. WHEN DIVERSIFIED, AT TIMES, TRENDS WILL GO YOUR WAY, AT TIMES THEY WILL NOT
In a diversified portfolio, it is inevitable that some parts will do well and others not. Anticipating trends consistently is impossible. Following trends incurs costs and most times you will be too late.

6. BE AWARE OF REVERSION TO THE MEAN
What’s hot today isn’t likely to be hot tomorrow. Investments invariably tend to reverse to the mean (7).

7. TIME IS ON YOUR SIDE
Take advantage of compound interest (8). Take both the large upswings as well as downswings with a healthy measure of salt.

8. HAVE REALISTIC EXPECTATIONS
The goal of investing is not to get rich quickly. For USD investors, numbers mentioned by John Bogle, can be a guideline: 7.5 per cent annual return for stocks and a 3.5 per cent annual return for bonds (9). Remember: it is only a guideline.

9. PAY ATTENTION TO COSTS BUT ACCEPT GRACEFULLY THAT ADVICE COMES WITH A PRICE
Costs matter. However, good advice or investment management will help you get the satisfactory returns you are looking for and is worth the price. Our bias prone decision making process is as much an enemy as costs are.

10. STAY THE COURSE
The secret to investing is there is no secret (10). This is the “Zen” of investing. When you own a well diversified portfolio, investing in the various asset classes, well selected with an eye on costs, you have the optimal investment strategy. Discipline is best summed up by staying the course (11).

Putting “sound data” in the Computer part of our brains, is not a one time action for investors but a continuous process. Keep reverting to the 10 listed in this article; it may help keep the Chimp at bay, with that the biases and so enable investors to get the performance of their investments they are looking for.

Written by Frank R. van Lerven.
CFP® Professional

 

Sources:

(1) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012
(2), (3), and (4) “The Chimp Paradox, The Mind Management Programme for Confidence, Success and Happiness” by Dr. Steve Peters, Vermillion, an imprint of Ebury Publishing, a Random House Group company, 2011
(5) Allen Roth, discussing “The Clash of the Cultures: Investment vs. Speculation” by John Bogle and quoting Bogle’s 10 rules for Investing, in Money Watch 22 August 22
(6) From: “Winning The Loser’s Game” by Charles Ellis, The McGrawhill Companies, 5th edition 2010
(7), (8),(9),(10,(11) All part of John Bogle’s 10 lessons, as discussed by Allen Roth, see (5)

Investors And Managing The Chimp Within Us

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Investors and their Decisions 6 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 6th, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process and if so, what the practical consequences and applications are for investors. This is the second article addresses managing these other factors (biases).

Investors And Managing The Chimp Within Us

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MANAGING YOUR MIND—THE CHIMP WITHIN US

In my last article, Investors and Their Decisions – 5, I suggested a practical remedy for investors to protect themselves from allowing biases to hinder investment results: work with a portfolio manager and/or a well-formulated investment policy. In this article I want to delve a bit deeper into ‘the workings of our mind’ and introduce readers to a theory that is currently being successfully used in top sports but lends itself well to fruitful investing too.

It is a theory, credited by – amongst others – Sir Chris Hoy, Bradley Wiggins and Victoria Pendleton (all Olympic gold medal winners in cycling) to have contributed to their successes (1). This theory was developed by Dr Steve Peters and published in his highly readable book “The Chimp Paradox “ (2). Let’s see if investors can benefit from the application of this theory!

Note: I do not claim in any way to represent Dr Steve Peter’s views, nor to have his consent to my interpretations. For a full understanding, readers need to read “The Chimp Paradox” themselves.

In my previous articles addressing biases and the notion that investors often make decisions that were not necessarily based on rational considerations, I often refer to ‘behavioural finance’. Dr Steve Peters is a psychiatrist and certainly not known for contributions to the realm of behavioural finance. However, Dr Peters begins with an explanation of how our brains work, and offers a working model that is not only easy to understand (3) but that can also be considered in the context of behavioural finance- particularly the area of behavioural finance my articles have focussed on.

Peters introduces us to the part of the brain he terms the “Chimp”. The “Chimp” refers to one part of our brain (the limbic brain) that works like an “emotional machine” (4). More interestingly, this emotional part of our brain, once activated and in motion, is ever so strong and works 5 times faster than the more ‘human’ parts of our brain (5). The “Chimp” is so called because its workings show many similarities to the behaviours of chimpanzees.

The basis for the “ Chimp’s” thinking are impressions and feelings. Here are some elements that make up the “ Chimp” “identity” (6):

  • Jumps to an opinion
  • Thinks in black and white
  • Prone to paranoia
  • Prone to catastrophic thinking
  • Irrational
  • Emotive judgement
  • Responds to danger by attacking or fleeing (7).

The good news is (still staying with Peters’ theory) that there are two further brain parts relevant to decision making processes: the “human” part and the “computer” part (8):

  1. The human part represents self-control, honesty, compassion, conscience, law-abiding, sense of purpose and achievement & satisfaction.
  2. The computer part thinks and acts automatically, using programmed thoughts and behaviours. It is a reference source for information, beliefs and values.

It is the interplay between “the chimp”, “the human” and “the computer” which is responsible for the decisions we make. Essential for a “high quality interplay” is to familiarize ourselves with the “chimp” within us. Once familiar, we stand a chance to manage the “Chimp”.

In the words of Dr. Steve Peters: “the chimp is an emotional machine that thinks independently from us. It is not good or bad, it is just a Chimp” (9).

There are many characteristics to the “Chimp” within us; as I mentioned, Peters’ book makes for a very fine read. One of them is that the “Chimp” has a strong need to be part of a “troop” (11). Herd instinct, following the crowd etc…sound familiar? Investors often making investment choices (buying, selling or holding) because friends/colleagues do…

So, what are some practical suggestions to help Investors keep their “Chimp” in check?

INVESTORS MANAGING THEIR “CHIMP”

Dr. Peters identifies three ways to manage our chimp: exercising it, boxing it and feeding it (12). For investors this can mean the following:

FEEDING THE CHIMP :
With small amounts, from time-to-time make a clearly speculative investment. For the “ Chimp” it will function like a “banana” (13). And/or, again with a small amount, follow a friend, colleague in a ‘hot tip’ investment.

BOXING THE CHIMP :
Recognize the “Chimp’s” existence. Do not fight the biases, the irrational responses when they come up. Instead, recognize them. This will “re-assure” the “Chimp” of its existence, that it has a place (remember, chimpanzees are territorial). The Chimp can then be “boxed” (14), or set aside to allow investors to make considered decisions, which in many cases requires time.

EXERCISE THE CHIMP :
Have a gambling account or a frequent trading account, with a small part of your investable assets. An account where you allow yourself to act impulsively and quickly, following emotions and snap judgements. This kind of account will satisfy the “Chimp’s” need to be active.

There is an important role for the computer part of our brain. I will tackle this in my next article.

Written by Frank R. van Lerven.
CFP® Professional

 

1) till 14) “The Chimp Paradox, The Mind Management Programme for Confidence, Success and Happiness” by Dr Steve Peters,
published 2011 by Vermillion, an imprint of Ebury Publishing, a Random House Group company

How Investors Can Manage Biases

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Investors and their Decisions 5 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 5th, addressing investors and their decisions. In particular, whether factors other than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. This article addresses Managing these other factors (biases).

How Investors Can Manage Biases

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MANAGING BIASES

In previous articles, I have aimed to familiarize the reader with a range of biases, cognitive as well as emotional ones, which can stand in the way of making sound investment decisions. The concept of ‘biases’ and their potentially damaging effect on decisions made by investors, belongs to the realm of Behavioural Finance, a theory developed by, among others, Daniel Kahneman.

In his bestseller “Thinking Fast and Slow”, Kahneman covers 40 decades of research on matters to do with the human mind and how it works. His book is not an easy read and is impossible to summarize. Simply said though, Kahneman attributes the influence of biases in our decision making process to the fact that we are prone to use the Fast Part of our brain (“System 1”) rather than the Slow Part of our brain (“System 2”) (2).

The list of biases is long, ranging from “over confidence” to “risk aversion”, all discussed in my previous articles. Is there anything investors can do to avoid these biases, stay clear of them or at least manage them? Is there anything investors can do to tap into the Slow Part of their brain rather than the Fast Part? Daniel Kahnman’s view is quite clear: “little can be achieved without a considerable investment of effort”.

Knowing about these biases by itself is certainly no guarantee at all that one is less prone to be subject to them. Kahneman says: “except for some effects that I attribute mostly to my age, my thinking is just as prone to overconfidence, extreme predictions, planning fallacy as it was  before I made these studies.” (3). There is hope though; for while in Kahneman’s words, “our thinking is prone to biases”, whether we act on bias-prone thinking is quite a different matter.

Biases play a role in every aspect of life and the journey to discovering our biases and then managing them can be viewed as part of a process of self-awareness. In the following articles, I will cover one or two perspectives which may be applicable to investors and their decision making. For now, though, there are for investors two practical ways to manage biases when it comes to investment decisions:

  1. Working with an investment adviser/manager;
  2. Working with an investment strategy & risk policy.

WORKING WITH AN ADVISER/PORTFOLIO MANAGER

Most investors will not be prepared to put in the “considerable effort” Kahneman is speaking about (4). I advise them to work with an investment adviser/manager who has made it his/her business to do so. The best guarantee to find this kind of quality adviser/ manager is to look for someone with a CFA designation.

Note 1: As I myself am part of a portfolio management firm with a manager at the helm who does have a CFA, I must immediately acknowledge my own bias on the matter;
Note 2: Sourcing Kahneman’s ideas, does not mean that I fully subscribe to his theory or that Kahneman support’s my advice.

My view is that there is a significant benefit in working with a portfolio manager who has discretionary authority, for many reasons. One is that it puts distance between the investor and his investments. So, while the biases may come up in the investor’s mind, they are not actionable. If Kahneman is right, it is the impulsive actions in response to bias which does the damage. Working with an adviser can eliminate such impulsive actions, and thus their potentially damaging impact.

The CFA designation (granted by the CFA Institute) earns its reputation mainly due to the gruelling process candidates must endure to earn the CFA charter. While the exam is very democratic and open to anyone with a bachelor’s degree, the only people with a realistic chance of passing are those who are serious about the field. The three general requirements to earn a CFA charter are to pass three exams, have an undergraduate degree (in any subject) and have three years related work experience in the financial area. (5)

Note: Investors who are not prepared or able to work with an adviser in a cooperative model or one where authority is delegated, are well advised to:

  • Put the same effort & work in that those do who complete their CFA accreditation;
  • Guard themselves against any notion that it takes little time to get educated.

INVESTMENT STRATEGY AND RISK POLICY

Central in all efforts, whether working with a portfolio manager, an adviser or making all investment decisions oneself, needs to be a well formulated investment strategy & risk policy. While this kind of policy may not be able to have answers for some of the curveballs financial markets throw from time to time, it will definitely guide investors (and their advisers) with their decisions through most market conditions. And again, perhaps most importantly, such a policy will stimulate the Slow Thinking of our minds, rather than the Fast (impulsive and often bias prone) part of our minds.

Written by Frank R. van Lerven.
CFP
® Professional

 

1) “Managing your Mind, the key to everything else” by Jack Speer, 13 Oct 2013, www.delta-associates.com
2), 3) and 4) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012
5) www.Investopedia.com

Investors And Emotional Biases

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Investors and their Decisions 4 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 4th, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. This article addresses Emotional Biases. An emotional bias is a distortion in cognition and decision making due to emotional factors (1).

Investors And Emotional Biases

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EMOTIONAL BIAS: BEWARE OF AVERSION OF LOSS!!

Consider these two problems (3); Which do you choose?

Problem 1: Get $900 for sure OR 90% chance to get $1000

Problem 2: Lose $900 for sure OR 90% chance to lose $1000

Most likely, if you are like the thousands of respondents before you, you will have selected the “$900” risk-averse option in problem 1. Most likely though as well, you will have selected the “90% chance to lose $1000” gamble option in problem 2. How come?

This is the explanation of Nobel prize winner Daniel Kahneman, in his widely acclaimed book “Thinking Fast and Slow” (4). It is the central theme in what is known as “prospect theory” and it has considerable implications for investors. In Kahneman’s words:

“The explanation for the risk seeking choice in Problem 2 is the mirror image of the explanation of risk aversion in Problem 1: the (negative) value of losing $900 is much more than 90% of the (negative) value of losing $1000. The sure loss is very aversive, and this drives you to take the risk.”

Hundreds of experiments have been done, on these lines, all leading to similar conclusions. This has led Kahneman to say that “Losses are weighed about twice as much as gains in several contexts”. That we humans are highly motivated to avoid loss (read: pain) is not new.

Skinner’s traditional psychology (behaviourism) also noted that humans (like animals) will move away from any stimulus causing pain and will move toward any stimulus offering rewards. Where behavioural finance brings in a new element is that avoiding losses outweighs seeking gains significantly.

LOSS AVERSION AND THE NEGATIVE IMPACT ON INVESTORS

Here are some examples of how the bias of loss aversion can have a negative impact on investors and their decisions:

  • Hanging on to losing investments, when better, alternative options are available; Taking profit on profit making investments rather than realizing losses on loss making investments, even when the profit making investments have better prospects than the loss making investments (disposition effect);
  • Investing additional resources in a losing account when better investments are available (sunk-cost fallacy);
  • Selecting funds which have not shown any downside (only to experience the downside once participating).

THE LETHAL COMBINATION OF LOSS AVERSION AND NARROW FRAMING:

FOLLOWING INVESTMENTS DAILY AND EXPOSING YOURSELF (UNNECESSARILY AND WITH NO USE) TO LOSS AVERSION

It is a fact of life that financial investments go up and down (stocks more than bonds, individual securities more than indices and so forth). Investments fluctuate. The level of fluctuation is often taken as the measure of risk. So, investors who follow their investments daily are going to experience both gains and losses on an almost daily basis.

If they take a broad “frame”, like the professional trader, there is no problem. The professional trader expects (or so he should) the daily ups and downs and is not emotionally affected. However, the amateur, the private retail investor, may use a “narrow” frame, focussing on the now. In that case (according to prospect theory) he will be far more affected by the daily losses than the daily gains and will be prone to taking counter productive actions such as churning one’s portfolio.

This is what Kahneman says on the matter (5):

Closely following daily fluctuations is a losing proposition because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and maybe more than enough for individual investors”.

In short, this is the message of behavioural finance: loss aversion is not helpful to participate in the superiors gains financial markets over time offer to private investors. For this reason: investors beware of inversion to loss!

RISK AVERSION IMPACTS GOLFERS AS WELL!

Prospect theory predicts that our stronger motivation to avoid losses than to achieve gains would show up in golf as well (6). Golfers near the hole are confronted with a choice: to putt to avoid a bogey (loss) or to putt to achieve a birdie (gain). This was tested by two economists (Pope and Schweitzer) (7). More than 2.5 million putts were tested (including those of Tiger Woods). The result: whether the putt was easy or hard and at various distances from the hole, players were more successful when putting for par than for birdie. The conclusion (8) being that sub-consciously golfers  put in just that bit more extra-concentration to avert loss (bogey)

Written by Frank R. van Lerven.
CFP® Professional

 

Sources:
(1) Wikipedia
(2) “When averting loss can lead to averting gains”, 11 October 2012, Beyond Bulls&Bears, Franklin Templeton
Investments
(3), (4), (5), (6), (7), (8) “Thinking Fast and Slow” by Daniel Kahneman, Penguin Books, 2012

Investors And Cognitive Biases (Continued)

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Investors and their Decisions 3 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 3rd, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. The previous article and this one address “Cognitive biases” which may affect investors to make decisions on a non-rational basis.

Investors And Cognitive Biases (cont.)

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OVER CONFIDENCE!

In my first article in the series (“Homo Economicus?”), I signalled that the concept of people (read: investors) making decisions rationally has become under fire by a relatively new approach to economic theory: behavioural finance, also referred to as behavioural economics. Behavioural finance identifies many biases. Two types can be recognized: cognitive and emotional biases. This article and the previous one discuss cognitive biases. Cognitive biases affect the way we think and can cloud our judgments.

The three cognitive biases discussed in the last article were:

  • Anchoring (fixing your mind on a specific number)
  • Bandwagon (joining the crowd)
  • Gamblers Fallacy (setting expectations to what is random).

I will now discuss three more:

  • Over-confidence (excessive confidence in ones own abilities)
  • Representativeness (making decisions based on stereotypes)
  • Myopia (short term-ism)

OVER-CONFIDENCE: EXCESSIVE CONFIDENCE IN ONES OWN ABILITIES

Refers to our boundless ability as human beings to think that we are smarter or more capable than we really are (1) We have too much faith in the precision of our estimates(2).

CLASSICAL EXAMPLE: 82% of people asked (in an experiment) say they are in the top 30% of safe drivers. When people say (again in an experiment) that they are 90% sure they are right about something, they are actually right 70% of the time. (3)

INVESTOR EXAMPLE I: “I can read markets, trends.., figure out when markets will crash and when they will take off.”
INVESTOR EXAMPLE II: “My skills as an investor are better than others”. (4)
INVESTOR EXAMPLE III: Tendency to attribute good investment results to one’s ability to make the right decisions, and bad results to “the markets”. (5)

REPRESENTATIVENESS

When we make decisions based on stereotypes, characterizations that are treated as “representative” of all members of a group. Recognizing an event that is similar to something we have seen elsewhere, and often incorrectly conclude that this event will be the same (6).

CLASSICAL EXAMPLE: When we see a man running out of a bank wearing a ski mask, assuming that he is a bank robber. (7) Note: what we are doing is using the ski mask and the running to represent the activity of robbing.
INVESTOR EXAMPLE I: Treating past performance of e.g. an investment fund as indicative of future results (without looking at any other data).
INVESTOR EXAMPLE II: Identifying a significant even such as stock market crash (e.g. Oct 1987, Autumn 2008) as a similar event as the 1929 depression. (8)

MYOPIA (SHORT SIGHTEDNESS)

A tendency in decision makers to focus on information immediately related to their judgment and to ignore other (less prominent) pieces of information (9). The tendency to being overly pre occupied by short term events.

CLASSICAL EXAMPLE: “Tip of the iceberg”: when we focus on only the part of something that can be easily observed, but not the rest of it, which is hidden. (10) (Referring to the fact that the majority of an iceberg is below the surface of the water.) Note: often (mis)used in an alarmist way to strengthen an argument.
INVESTOR EXAMPLE I: Short-termism: buying or selling based on an immediate (economic, political) event.
INVESTOR EXAMPLE 2: “Buying what is hot”. Making an investment decision based on the recent (strong performance). Today it would be US Large Cap, a few years ago it was Emerging Markets.

Benjamin Graham, the original value investor, warned against myopia when he famously remarked: “In the short run the market is a voting machine but in the long run it is a weighing machine !” (11)

Our inclination to cognitive biases is also used in marketing, advertising and promotional material to entice us to buy and by the media and news channels to get our attention. So private investors need to be aware of what is coming at them!! This is also where educated financial planners can play a crucial role.

Written by Frank R. van Lerven.
CFP
® Professional

 

Sources:

(1), (3) and (4) “Psychology and Investing”, 25 February 2013, www.morningstar.co.uk
(2) and (5) Investor Behaviour 13.1 www.web-books.com/eLibrary/NC/B0/B65/61MB65.html‎
(6) and (7) “Rational Investment” www.rtnlblog.net
(8) “Heuristics in Investor Decision making”, The Journal of Behavioral Finance
(9) and (10) “Psychological myopia: a tendency to think shortsightedly”
www.understandinghuman.com
(11) “A long history of myopoc investing” by John Plender, www.FT.com 15 May 2011

Investors And Cognitive Biases

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Investors and their Decisions 2 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 2nd, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. This article and the next one address “Cognitive biases” which may affect investors to make decisions on a non-rational basis.

Investors And Cognitive Biases

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COGNITIVE BIASES

In my first article in the series (“Homo Economicus?”) I already signalled that the concept of people (read: investors) making decisions rationally has become under fire by a relatively new approach to economic theory: behavioural finance, also referred to as behavioural economics. Generally, three scientists have become associated with its foundation: Daniel Kahneman, Amos Tversky and Richard Thaler (2). In 2002 Kahneman received a Nobel Prize (3) for his work in Prospect Theory, which provides a theoretical frame work for behavioural finance.

Behavioural Finance (4): A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioural finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

Before delving into biases, here is one notion worthwhile considering. This is that biases provide one possible explanation for the astounding fact, recorded time and again, that private investors underperform the mutual funds they invest in as well as the indices. A recent study shows that private investors underperformed the S&P500 by 5.92% p.a. covering a 20 year period (5).
Behavioural finance identifies many biases, the list is long (6)! Two types can be recognized: cognitive and emotional biases. This and the next article address cognitive biases.

Cognitive biases influence the way we think. At the bottom of this page, readers will find a couple of test questions, which will give a direct experience about what these biases are about. The good news, according to adherents to the behavioural finance theory, is that cognitive biases, once recognized, can be corrected and there is also a suggestion that financial advisers can play an important role here (7). I will discuss 6 cognitive biases (of which 3 in this article):

TEST QUESTION 1 (12):

A town has two hospitals: one large and one small. Assuming there is an equal number of boys and girls born every year in the United States, which hospital is more likely to have close to 50 percent girls and 50 percent boys born on any given day?

A. The larger
B. The smaller
C. About the same (say, within 5 percent of each other)

TEST QUESTION 2:

A team of psychologists performed personality tests on 100 professionals, of which 30 were engineers and 70 were lawyers. Brief descriptions were written for each subject. The following is a sample of one of the resulting descriptions:
Jack is a 45-year old man. He is married and has four children. He is generally conservative, careful and ambitious. He shows no interest in political and social issues and spends most of his free time on his many hobbies, which include home carpentry, sailing and mathematics.

What is the probability that Jack is one of the 30 engineers?

A. 10-40 percent
B. 40-60 percent
C. 60-80 percent
D. 80-100 percent

ANCHORING: FIXING YOUR MIND ON A SPECIFIC NUMBER

The tendency to focus too much on something first presented to you, leading you to falsely perceive the value or significance of all things around it (8). Classic example (9): An audience in the US was divided in two groups, A and B. Both groups were asked what the number of countries is in Africa.

However, before answering this question, both groups were asked to answer another question first, different for the A and B group. The A group was asked whether there are more than 5 countries in Africa and the B group whether there are more than 180. Interestingly enough the A group answered the second question with a much lower number than the B group.

Both groups had “anchored” on either 5 or 180 and it had affected their answer; Investing example 1 (10): When investors “anchor” to the long term return of securities, e.g. 8%, without considering market conditions, volatility, inflation and so forth; Investing example 2 (11): When investors believe that the nominal price of a stock matters when compared to another stock.

BANDWAGON: JOINING THE CROWD!

The “herding effect”, where you feel comfortable doing what many other people are doing. There is supposedly less risk in doing what many other people are doing, even if they are all engaging in the same irrational behaviour (13).

Classical example (14):

Voters tend to go, in the latter part of election campaigns, with the winning party; Investor example 1 : Investing in a share because your friends/colleagues do; Investor example 2 : Investing or liquidating when most other people do; Classical antidote (15): “Be fearful when others are greedy and greedy when others are fearful”, Warren Buffet.

GAMBLERS FALLACY: SETTING EXPECTATIONS TO WHAT IS RANDOM

When you erroneously believe that the onset of a certain random event is less likely to happen following an event or a series of events (16).

Classical example (17): When shown a sequence of coins flipped, where the 6 has come up each time, betting on any other number than the 6 as the next one coming up; Investor example 1 (18): Investors betting a stock will go down after a period of e.g. five upside trading sessions. The opposite: investors
betting a stock will go down after a period of e.g. five upside trading sessions is referred to as “the hot hand bias” (19); Investor example 2 : Investors betting a stock fund will do poorly in the coming year because it has done well in the past years.

In my next article I will discuss 3 more cognitive biases.

EXPANATORY NOTES TEST QUESTIONS (20)

QUESTION 1

Most people select answer C; we expect things to follow a proven pattern regardless of size. But size matters. A small sample size (i.e., the small hospital) will often contain extreme proportions, while a large sample size (i.e., the large hospital) will more likely reflect real-world distributions.

QUESTION 2

If you answered anything but A (the correct response being precisely 30 percent), you have fallen victim to bias.. When Kahneman and Tversky performed this experiment, they found that a large percentage of participants overestimated the likelihood that Jack was an engineer, even though mathematically there was only a 30-in-100 chance of that being true. This proclivity for attaching ourselves to rich details, especially ones that we believe are typical of a certain kind of person (i.e., all engineers must spend every weekend doing math puzzles) behavioural finance explains by the workings of our brains.

Written by Frank R. van Lerven.
CFP
® Professional

 

Sources:

(1): “A Visual StudyGuide to Cognitive Bi.ases” by EricFernandez,RoyalSocietyofAccountplanning.Blogspot.com;
(2),(3),(4),(6),(14),(17), (19) : Wikipedia and Investopedia
(5),(9): “Cognitive Biases and Their Impact on Investment Decision-Making” by Jay D. Franklin, 27 June 2011
(7),(10): “Controlling the Urges: How biases influence our investment decisions” by Jay Mooreland, Jrnl of Fi Pl May 13
(8),(11),(13),(16): “12 Cognitive Biases that prevent you from being rational” by Cullen Roche, 15 January 2013
(12),(20): “The quiz Daniel Kahnemann wants you to fail”by Jaime Lalinde,Vanityfair.com/businessfeatures/2011/12
(15), (17), (18): “Behavorial bias-Cognitive vs. Emotional Bias in Investing” by Tim Parker, Investopedia

Investing Is Not A Rational Process

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Investors and Their Decisions 1 of 7 – by Frank R. van Lerven CFP® Professional

A series of articles, this one being the 1st, addressing investors and their decisions. In particular, whether other factors than rational considerations play a role in the investment decision process, and if so, what the practical consequences and applications are for investors. We will start with the concept of the “Homo Economicus”, the backbone for the notion that investors make decisions rationally, and its challenges.

Investing Is Not A Rational Process

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“HOMO ECONOMICUS”?

The notion that investors make decisions not just rationally but for many other reasons may come across as “stating the obvious”. Is not that just what we humans are about: subjective, flawed by biases, capable of extraordinary intelligence as well as astounding stupidity, gifted as well as restricted? Do not we see in the smaller as well as the bigger decisions made day-to-day by ourselves as well as by people in the limelight (be it politicians or celebrities) that decisions are not just made rationally? In fact, whether we humans are rational beings, yes or no and to what extent, has been a central topic in philosophy for as long as the records go back. And it seems that what view prevails is like a tipping scale, whose balance varies.

On the one end of the scale the view that we humans are largely driven by animal instincts (central in Sigmund Freud’s theory) and on the other end the view that we are rational beings (put forward by Descartes, Adam Smith and others). The idea that we are rational beings is central in many economic theories, captured in the term “HOMO ECONOMICUS” (2): humans are rational and self-interested actors who have the ability to make judgments toward their subjectively defined ends. People seek to attain very specific and pre-determined goals to the greatest extent with the least possible cost.

The “self-interest part” is well put forward in the following simple example given by Adam Smith (3):

“It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner but from the regard to their own interest”.

In these articles I will focus more on the “rational decision making” characteristics of the homo economicus.

So, in a way, it is understandable when viewing investing as an “economic activity” that it was the science of economy that started to make assumptions about investor behaviour rather than the science of psychology; and that this assumption became “the homo economicus”. So, the assumption was made that investors make their decisions rationally. And this notion nicely ties in with the idea that financial markets are rational and efficient, as put forward by the efficient market hypothesis (4).

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices (5).
Note: In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made (6).

There was only one problem: markets do not always behave rationally and neither are they always efficient…There are several examples of this; for now let’s just recognize the phenomenon of stock market bubbles and crashes.

So, for this reason, we may understand why the following, key question has come up when it comes to investors and the decisions they make (7):

“Why do market participants make systematic errors (when they are not supposed to)? Such errors affect prices and returns and create market inefficiencies?”

Aiming to answering this question has become the domain of behavioural finance, which combines the sciences of economics and psychology (8). Behavioural finance challenges the assumption of the Homo economicus and states that investors in their decision making processes are prone to biases. Biases which cloud the rational process.

Two types of biases are generally recognized (9):

  1. Cognitive Biases. An example being the “overconfidence factor”. A range of experiments show that we tend to attribute too much weight to our investment skills when we made a good investment decision, leading to errors in subsequent investment decisions;
  2. Emotional Biases. An example being Regret Aversion: investors may hold on to a losing stock (when better choices are available) to avoid regret.

Note: I will review these biases more in detail in the following articles.

We can apply perspectives outside behavioural finance, challenging the “homo economicus” notion, and providing explanations (and solutions!) for irrational decision making as well. In fact, there are many. One is currently very much in the limelight, as it is used (with success) in top sports in the UK. This is the “Inner Chimp Paradox Theory”, put forward by Dr. Peters (10). The practical application of this theory (and with Peters active assistance) has helped among others Chris Hoy, Victoria Pendleton and Bradley Wiggins gaining  heir gold medals.

Peters is firmly in the “Freud tradition” (like Freud was, he is a psychiater). The essence of his theory is that part of our brains is “animal wired”, best to be compared to that of a chimpanzee. And that this part of the brain responds 5 times faster to any situation than the human (more rational) part of our brains. The key is to manage this “chimp part”. If Chris Hoy, Bradley Wiggins and other top athletes benefitted from this model and its application, how could investors?

Both adherents to behavioural finance (11) as well as people like Dr. Steve Peters, come from very practical perspectives to the conclusion that self awareness in decision making is key. So, interesting enough, investors whose motive for investing is to make money work, are invited to take a journey in self awareness as well. Of course that is, if indeed they come to the conclusion that investing is not just a rational process. Readers can make up their own minds about that. In the next articles I will cover a range of biases investors are prone to.

Written by Frank R. van Lerven.
CFP
® Professional

 

Sources:

(1): inspired by artist Antruejo,www.toonpool.com
(2),(3),(4),(6),(7),(8): Wikipedia
(5): Investopedia
(9): Jay Mooreland: How Biases influence our Investment decisions. Journal of Financial Planning
(10): Dr. Steve Peters: The Mind Management, Vermillion, London, 2011
(11): Doug Lennick in Moral Intelligence and the Value of Behavioral Advice. Journal of Financial Planning

Building Retirement Capital

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High on the list of financial objectives for expatriates is the desire to create sufficient funds for retirement and, thus, be financially independent. There are several possible avenues one can take in order to work towards achieving this objective:

  • pension plans (which come in many forms);
  • government plans;
  • building capital through financial assets, which are liquid;
  • building capital through accumulating real assets (e.g. property);
  • creating value in one’s own company (which can be realized).

1) Discipline and persistence

There are spectacular examples of young entrepreneurs being able -accidentally or not- to realize astounding value in their company. A recent example of this is Mark Zuckerberg (age 26), founder of Facebook, whose current net worth is estimated to be 4 billion. (1)

There is also the well-known fact that Microsoft’s success produced a large number of “Microsoft millionaires” among its early employees, where shares represented a substantial part of their remuneration. An estimate in 2000 put the number at 10,000. (2)

There are also examples closer to home. Particular in the oil and gas industry, some expatriates with an entrepreneurial spirit, have been able as well to build value in companies set up by themselves and realize this in financial terms.

This article addresses those readers for whom, what Brian Tracy calls (3) “The Law of Accumulation” would apply: “every great financial achievement is an accumulation of small efforts and sacrifices”. In order to accumulate, discipline and persistence are essential.

2) Time Value of money

The need for persistence and discipline ties in with “The Eighth Wonder of the World” (a quote assigned to Albert Einstein (4)): compound interest! Compounding interest is the process of generating earnings on an asset’s reinvested earnings. To work, it requires two things: the re-investment of both earnings and time (5). The more time you give your investments, the more you are able to accelerate the income
potential of your original investment.

Readers will have seen the tables before. Unfortunately, they are often misused by overzealous pension plan sellers. The reality is that the growth assumptions are truly just that: assumptions. But compound interest is powerful.

3) Forced saving

Those expats working for large international firms or institutions will automatically build towards retirement through employer pension plans; such plans come under various definitions such as benefit plans, money purchase plans, final salary plans, deferred plans, 401(k) plans and so on. What is great about these plans is that participation in most of these plans is obligatory. So, one becomes a “forced saver”: the discipline and persistence needed to benefit from the time value of money is automatic!

SPECIAL OPPORTUNITY 1: COMPANY MATCHES VOLUNTARY CONTRIBUTIONS
Any plan where the employer matches voluntary contributions represents a unique opportunity for extra savings and should be utilized when possible.

SPECIAL OPPORTUNITY 2: COMPANY SHARES
Global companies often remunerate their executives with company shares. This can take place in various forms. Substantial holdings in one’s own company can be extremely lucrative (Microsoft example) as well as disastrous (World Com and Enron examples). Overall a balanced holding in many cases and (again) over time will work out very well.

INTERNATIONAL PENSION PLANS
International pension plans, core product of most investment advisory firms for expatriates, aim to match in the need of creating retirement capital yourself. There are pros and cons to these plans, so participation deserves a lot of consideration. However, they may help people save, who otherwise would not.

4) Building retirement yourself

Expats working for themselves or for local firm/ organizations in most cases will have to build retirement capital entirely themselves. As I mentioned in my previous article, many of the expatriates who have company pension plans may still be keen to create retirement capital independently as well. When the responsibility for creating retirement capital is -entirely or partly- on one’s own shoulders, discipline and persistence need to be enforced by oneself. This comes easier to some than to others…

5) Personality types and Saving

An interesting study, the Retirement Confidence Survey, was concluded in 1998 by the Employment Benefit Research Institute in the US (6). This survey aimed to gauge the views and attitudes of both
working and retired Americans with regards to retirement. This study identified 6 types of personalities, giving some perspective as to which attitudes are helpful for saving, and which attitudes are not.

PERSONALITY TYPES AND SAVING

The Denier (10%): “Retirement is so far away”
The Struggler (9%): “Save? If I have $5 leftover I save it”
The Impulsive (20%): “I should plan and save but, oh..I need to buy a new suit”
The Cautious Saver (21%): “I put a set amount into savings each month and hope it will be enough”
The Planner (23%): “I am saving, investing and planning for a secure future”
The Retiring Saver (17%): “I have been sacrificing and saving for years; now I am enjoying”

Rarely do people fit neatly in one type of personality. Readers may recognize themselves in several of these 6 characteristics. Age is also likely to influence which of the personalities you most associate with. I would predict that, as we age, we pay more attention to planning and are more able to apply the persistence and discipline that achieving financial independence requires. Most expatriates are money conscious and I expect will score highly on the types: ‘Cautious Saver’ and ‘Planner’.

6) The investment of what we save

Where our savings go to – the actual investment – is as important as our ability to save in the first place. Most of my articles cover this topic. In the context of building retirement capital, the following points are important:

  • defined benefit plans are in most case very conservatively managed; this has worked out well for its investors over the last decade.
  • Self-directed plans, such as 401(k) plans, when invested aggressively (e.g. 100% equities) carry lots of volatility, and thus risk, compared to defined benefit plans. The same holds true for investment accounts and savings plans that investors direct themselves.

The consequence of this is that the “forced saver”, who in his package of investments has a defined benefit plan (final salary plan), has a built-in conservative dimension that the expatriate, who must build retirement capital entirely himself, does not have. I would suggest that the latter always has a strong conservative component in his invested savings.

7) Ability to save and budgeting.

The ability to save and the amounts we can save, of course, are also influenced by our levels of earning. For some expatriates, their levels of earning (and costs covered by their company) will, in themselves,  automatically generate significant savings every month. For others, remuneration does not automatically result in savings. For them the ability to budget and live within a set budget is key. This topical issue will be the subject of my next article.

 

Notes and sources:

1) Forbes Billionaire list March 2010
2) “The Few, the Tech-Savvy Few: Option Millionaires” by Wendy Kaufman 11 February 2007
3) Brian Tracy Newsletter 17 December 2010
4) Union Plus Retirement Planning Center website
5) www.investopedia.com
6) EBRI Issue Brief, August 1998: The 1998 Retirement Confidence Survey”
7) EBRI Issue Brief, August 1998: The 1998 Retirement Confidence Survey”