October 2003
"Only two things are infinite, the universe and human stupidity, and I'm not sure about the former" - Albert Einstein
For anyone who has ever managed an investment portfolio, either for themselves or, as John and I have, for hundreds of families entrusting us with millions of dollars of their hard-earned wealth, it certainly doesn't come as any surprise to learn that the human mind can be a formidable enemy of even the most rational of investors. In fact, an entire new branch of finance has been developed to counter the academically popular notion that the stock market is always right. After the stock market bubble and its subsequent bust over the past five years, it should now be crystal clear to anyone involved in the capital markets that it is anything but a methodical and rational place. But despite this, and despite the excessive finger pointing that has ensued, it is our belief, that the market isn't to blame. Rather, we feel that simply being human is the primary culprit. Gaining a better understanding of the common mental mistakes that all humans are hard-wired to make is a vitally important factor in achieving long-term investment success.
Sometimes what works in nature doesn't necessarily translate into success in the modern world in which we live. Essentially, we want to highlight a few common cognitive illusions that routinely crop up to cause investors significant financial pain. These illusions come very naturally to us all and, no doubt, have served our species well over years. Unfortunately, that's exactly what makes them so difficult to overcome.
From Success ... Confidence ... From Overconfidence ... Failure
We are very optimistic creatures and it makes a lot of sense for the progress of our species to possess this attribute. It gets us through the trials and tribulations of everyday existence, so it should not come as a big surprise that we try frame most things in a positive light. Framing a situation that we haven't seen before helps us to make quicker decisions by relying on what can be called "mental short-cuts". Have you ever heard the phrase, "Stocks are the best place to invest for the long haul." or how about this one, "Buy stocks on dips". Generalizations, easy rules and simplistic understanding are really just mental short-cuts that help you make quick, confident decisions, yet not necessarily better ones. To illustrate the concept of framing and overconfidence, follow along with this example of a study designed to highlight these issues.
First, a researcher takes a full deck of 52 cards, randomly picks out one card, holds it up for the crowd to view, and then reshuffles the card back into the deck. You will win $100 if the researcher picks out the card again on the first try. To skip through the complicated math, probability says that the ticket to play this game is worth around $2. In other words, that is the most a person should ever pay for a ticket to play this game. If you were to pay more than $2, you are statistically doomed to failure over the long haul. But it is certainly fun to dream and it is precisely why playing the lottery or visiting the casino is such a popular past-time.
Now, here is where things get interesting. When the holder of a ticket is asked how much they would sell their ticket for, the holders' average asking price was $1.86. An accurate figure, really. But that's the average asking price when someone else is going to pick out the winning card. When the game was slightly altered, the results changed.
When, from the start, the person playing personally picks out the card, personally reshuffles it back into the deck and is given the chance to personally pick the winning card out of the deck again, the average price they place on their chance on their ticket leaps to $6 per game! In other words, the value of the chance to win has tripled in their minds. Why?
The explanation can be directly traced back to the concept of personal involvement and a positive attitude. Confidence in one's ability tends to grow with familiarity, whether or not that familiarity actually adds to your odds of winning. The people in this example card game were able to physically touch "their" card. By feeling it, by holding it, by thinking and dreaming about it, it made them believe that they were three times more likely to pick that card out of the deck again. There are definite parallels in stock picking. People gain comfort by owning their employer's stock, their favorite store's stock or the stock of the company that made their first car. The same can be said about owning a stock whose name you recognize from the financial press. As long, of course, that what you read had a positive spin. The reality and mathematics point to the likelihood that investors systematically over-pay for this familiarity and it breeds a false sense of over-confidence in their investing abilities. In other words, and this is really important, increasing levels of confidence frequently show no correlation with greater success.
The Curse of the Pattern Seeking Animal
On to our next financially disastrous mental error: our tendency to extrapolate the recent past into the future. There are numerous examples of this kind of behavior outside the world of investing, like believing that the odds of next coin flip being a heads is far greater than 50/50 given that the past five flips all happened to come up tails or believing that the basketball player with the "hot-hand" is more likely to make his next shot than at any other time. We are literally hard-wired to see order where it doesn't exist and interpret accidental success to be the result of skill.
Here is an often cited example of how this tendency to seek a predictable pattern results in poor investment returns. It is common knowledge that investors chase past performance in pursuit of capturing large future returns. The hot mutual fund from the recent past is invariably purchased at precisely the wrong moment or investing in the latest popular sector, that is being universally touted by the popular press, only to see it plummet right after it is was acquired. To put this into perspective, one study has concluded that performance chasing caused the average mutual fund investor to earn about 1/2 the annual return of the average mutual fund from 1984 to 1995. How can this be, you ask? It is explained by the concept of chasing past performance and falsely believing the past will repeat itself indefinitely into the future.
Which is a fresher lesson, the huge gains of the 80's and 90's or the huge losses of the early 2000's ?
Are investors today simply seeking to re-coup their long lost money the easy way by investing in their favorite, familiar, past star performing technology and large-cap stocks that helped them grow over-confident in their investing abilities during the 80's and 90's? Here are some examples of the kinds of stocks that have been largely responsible for this year's gains. Most readers will recognize these names, but please don't mistake that fact alone as comfort or conservatism. Juniper Networks has jumped 123%, Intel is up 78%, Genentech has gained 143%, American Airlines up 71%, Nortel Networks has jumped 160%, Cisco is up 51%, Lucent up 74%, Yahoo has gained 119%, Amazon up 160% and E-trade has vaulted 91%. The list goes on and on, especially when you expand the horizon to much smaller, unprofitable or risky debt-laden companies.
A market that is driven by mostly hype, hope and a heap of performance chasing momentum speculators is not sustainable nor is it an environment in which John and I sleep easily. Regardless, this is the time when portfolios managers must simply manage and maintain a focus on principal protection, first, and opportunistic bargain hunting, second. While not predicting that these gains will disappear in the short-term, it begs the question of just what value people are seeing in certain segments of today's stock market? Other than the pleasant, yet ultimately empty, benefit of self-reinforcement in watching the market value of their risk-laden portfolios rise, we would contend that they are needlessly exposing themselves to significant downside potential going forward. Again. Some lessons are hard to learn the first time through. But, then again, maybe it is easy for people to ignore lessons they never really learned in the first place.
Jason P. Tank, CFA
jason@frontstreet.com