Warren Buffet once said that you only get rational behaviour when one combines sound intellect with emotional discipline.
So much for the efficient market hypothesis (a theory that market participants are perfectly rational)! It’s been shown that most money managers can’t beat their own benchmarks and it has nothing to do with their intellect, as there are a ton of brilliant minds on the Street of Dreams. It does, however, have everything to do with their emotionalism and biases.
Emotions can be great assets – they motivate us, warn us and increase the overall satisfaction of our lives. But in the investing world, emotions are a liability to us all. There are many cognitive biases that exist, but we’ll break down only two of the most common. We’ve seen examples of these throughout our careers and even the uninterested market observer will have seen most of these at some point in their life.
Remember the widespread Y2K fears that the turn of the millennium would somehow lead to software failures in banking, utilities and military systems around the globe? Observers predicted panic and chaos and even the end of the world. But despite that fear, one sector of the market was booming – technology. In 1996, former Federal Reserve chairman Alan Greenspan (who we had the pleasure of meeting recently) remarked that markets had reached a level of irrational exuberance. He was right, albeit early in his call.
Into the late ’90s, tech stocks were roaring and Main Street pounced into the sector with reckless abandon, which was reminiscent of the final stages of the ’20s boom cycle. When tech stocks only go up for five years straight, it’s hard to imagine they could ever go down. Combine that with everyone’s neighbour explaining to them how much money they just made on Pets.com and you can understand how so many people got caught up in the euphoria.
Have you identified the bias yet? It’s well-known and is commonly referred to as herding. The dotcom herd influenced many investors to drop money into technology companies with the reassurance of seeing so many other investors do the same thing. Be wary of running over the cliff with the herd.
Losing money on any investment is never an enjoyable experience. What’s even more frustrating is admitting to being wrong about a stock pick.
Many investors hold onto their losers’ years after they drop in value. They believe eventually the battered-down stock will rebound in price and they will be able to sell it at their cost, allowing them to break even. Even though most of these types of investors have no idea how to evaluate a company, they remain bound to their original purchase price. This is called loss aversion or anchoring. Losing money on an investment is too painful for some investors, so they convince themselves that the stock price will recover one day. Unfortunately, this type of investor bias is common and many people are left holding stocks in their portfolio that are worthless.
Investment decisions should be based on a well-crafted and thought out strategy, rather than ad hoc when emotions run high in times of high market volatility. Toning down rampant emotionalism is one of the best ways to improve not just investment results but life results as well.
Lori Pinkowski is a senior portfolio manager and senior vice-president, Private Client Group, at Raymond James Ltd., a member of the Canadian Investor Protection Fund. This is for informational purposes only and does not necessarily reflect the opinions of Raymond James. Past performance is not necessarily indicative of future performance. Lori can answer questions at 604-915-LORI or [email protected]. Listen to her Monday mornings on CKNW at 8:40 a.m.
