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Markets: Why Investors Fail
New York: February 28, 2005
By John R. Stephenson

It seems so simple. Buy low and sell high. To the uninitiated, this couldn't be more straightforward and logical. We've heard it all before and yet for most of us we don't do it very well. Although the rules appear simple, most of us have trouble following them. But buying low and selling high, although easy to say, is hard to do. For one thing, how do you know when you are buying low? How do you know when you are selling high? Most of us do not have the time, let alone the inclination, to do the complex analysis required to make these seemingly straightforward decisions. But, as it turns out, it is not just our math skills that hurt us as investors - it is also our nature.

Nothing is as exciting as the lure of fast and easy riches. Look around you and you'll notice the promise is always the same - "I did it and so can you." But can you? Are fast and easy riches just available for the taking? Common sense dictates that they're not - yet we all are suckers for a great story. Whether we are amateur investors, or professionals, we all love a good story. So much so that we tend to rush over the details and "buy the story." This love of a story is the single greatest failing that we as investors make and leads us to chase past performance rather than carefully examining the fundamentals of the situation. This problem of falling in love with a story and chasing past performance occurs not only when we "go for it" with a hot stock tip but also when we buy mutual funds. We end up chasing the story (past performance). The result? The average investor has worse performance than that of the average mutual fund.

Stories sell. Facts don't. Salesmen and professional speakers know that people love to hear a good story. Those who rise to the top of their professions whether it is politics or business are often excellent raconteurs. We are all predisposed to a good story. Even though studies have proven that investments in value stocks (low P/E with slower growth prospects) outperform growth investing (high P/E stocks growing quickly) with less risk, investors prefer growth investing to value investing. The reason? The story associated with growth investing is way sexier than it is for a value investment. But why is it that we love a story so much? Why do we as investors, who are rational beings, make these same mistakes over and over again and continue to buy the story?

As it turns out, our minds are not well suited for the world of investments. For decades, academic research in the field of finance has focused on the investor as a purely rational being. Researchers have studied and hypothesized that stock markets were efficient (all information about a stock is already reflected in its price) and that investors acted rationally. Stocks could be priced based on strict mathematical criteria that were known and determinable. But then something in the field of finance changed.

In 2002, Professor Daniel Kahneman of Princeton University won the Nobel Prize for his psychological insights into economic science. This was something revolutionary - a Nobel Prize being awarded not for the typical rational and numeric approach to the economics of investing but rather for behavioral finance. Behavioral theories of investing have been around for some thirty years, but this award was validation that the stock market might not always be a purely efficient market (where securities were always accurately priced) and that in fact human emotion might well play a significant role in the investment process. For investors schooled in "the efficient market hypothesis", this was heresy - no longer could the stock market be exclusively viewed as rational. From this point onward, economic science had valiadated that human behavior, in all its irrational forms, had a place in the "science" of investing. What this research suggests is something the man on the street already knows - that profitable trends exist in the stock market. Not only do these trends exist, but these trends continue for much longer than pure rational or efficient economic analysis would suggest. But why is this so?

The reason is a simple one. Stock markets are comprised of human beings who buy and sell stocks all day long. But, for most of our history, we lived in hunter-gatherer societies and then later in small subsistence agrarian communities. Life during these times was hard and people were constantly surrounded by threats to their very existence. In such an environment, survival depended on the ability to react quickly to dangerous situations. When danger arose there was no time for analysis. As such, we evolved with a highly developed emotional response to both opportunities and threats. Although the threats are different today, the fundamental need to survive has not changed. The result? Our brains are hard wired with a bias for action. Our emotions rule our minds for a good reason - our survival depends on it. Unfortunately, this emotional bias doesn't translate well into the world of investments.

Not only do emotions drive our decisions, but we also have a tendency to deceive ourselves. This self-deception takes the form of little lies that we tell ourselves in order to justify our actions. It is something we all do to make sense of the world around us and to appear consistent (or congruent) in our behavior. If we don't know the facts - we make them up! This ability to deceive ourselves actually served an evolutionary purpose. Within a communal living environment, the ability to spot others who are lying is a huge advantage and key to one's survival. In order to fool others, it helps if we can first, fool ourselves. If we can first convince ourselves that our behavior is congruent, then others will tend to believe it as well. But this tendency to rationalize our behavior has huge implications in the world of investing.

One of the ways that this self-deception manifests itself in the world of investing is that we have a tendency to think we know more than we really do. This self-deception occurs every time we buy a stock. We rationalize that our investment decision was carefully considered and that our view is correct. Otherwise, why would we have bought the stock in the first place? This situation is further compounded by another false assumption of investors - that the more information we have, the greater our ability to make good investment decisions. Why is this a false assumption? Because more information is not necessarily better information. The tendency to think we know more than we really do, coupled with the belief that more information equates to better investment decisions, makes us overconfident and overly optimistic.

Overconfidence is a killer for investors. It blinds us to the investment risks we are taking and makes it difficult for us to recognize potential threats to our investment portfolio. Not only does overconfidence and over-optimism tend to blind us to the risks we are taking, but it also helps to exasperate our natural tendency to rely more heavily on our own judgment, rather than the judgments of others - even experts. This potent combination of overconfidence and an over-reliance on our own judgment leads investors to over react to good news and not to react strongly enough to bad news on stocks we like. Familiarity in the world of investing does not breed contempt. It breeds overconfidence. This can be a dangerous combination for investors, with the result that we tend to underestimate the risks and overstate the opportunities.

This human need for internal congruence causes us to look for information that agrees with us. Psychologists refer to this as confirmatory bias. In all aspects of life, we tend to surround ourselves with those who support rather than refute our views on a wide range of subjects. It is our need as human beings to seek out certainty in an uncertain world that causes us to associate with others who echo our beliefs and judgments in all manner of things whether that is investing, religion or politics. But this can spell trouble for investors. If everyone in our circle of influence agrees with our position, how can we hear opposing viewpoints? How can we look at an investment with any objectivity if all around us are like-minded individuals? The result is that our personal network tends to hinder our investment decision making rather than strengthening it.

Once we do form an opinion on a stock or a trend, we tenaciously hold onto our views (conservatism bias). If we ever get around to changing our opinion on a stock or a trend that we believe that we have observed in the market, we do so slowly and generally only when the evidence to the contrary is overwhelming. Once a position has been stated and accepted, it is very difficult for investors to move away from that position. Not only do amateur investors tend to cling to a viewpoint for a long time, but professional investors do as well. This is evident when you examine the performance of stock analysts who are on average wrong some 50% of the time. Stock analysts, the so-called professionals in the investment profession, are no different it turns out than you and me when it comes to picking investment winners or losers. They tend to be dogmatic in their views and only change their views when faced with irrefutable evidence. Stock analysts are excellent at looking in the rear view mirror and telling you what has happened but they are unlikely to change their views early enough to be of any real use to you as an investor.

This inability of investors to change their viewpoint is in large part attributable to a tendency that people have to anchor their views. Once a certain subset of information is presented, that subset serves as an anchor for our view of a stock or a trend. If prices on technology stocks have been going up for the last two years, then that trend of consistently higher returns in technology stocks (or energy stocks or whatever) serves as an anchor for our resultant viewpoint. The result? Most investors, confronted with that specific subset of information on technology stocks, would buy technology stocks on the belief that returns from technology stocks will continue to rise. The anchor for that viewpoint being the two years of positive investment returns from technology stocks. As investors, we tend to think that the current trend will continue indefinitely even though research has shown that all trends eventually end or regress back to the mean (long-run average price). The reality of this situation is that it is just as likely that technology stocks will drop in the coming year, as it is that they will increase in value.

To become better investors, we need to understand that it is emotion rather than logic that rules the roost. In order to combat our natural tendency to let emotions dominate decision-making, we need to try and interject a little structure into our approach to investing. For starters, why not consider how information is being framed. Try asking yourself the following questions:

•  Where did I get this investment idea?

•  What is the agenda of the person or firm who told me the story?

•  Is this all the data there is?

•  Is it complete?

•  What do your contrarian friends think of this investment?

•  Can they poke holes in your investment thesis?

•  Can you back up your arguments with hard facts rather than a gut feeling?

Make it a habit to seek out people who are unlikely to agree with you and run your investment ideas by them. They should help you spot the pitfalls in your investment thesis before you leap. Try and get as much independent unbiased information as you can about a potential investment and listen to the opinions of experts to see what they are recommending. Do your own thinking and try and look at the facts before you get "sold" on the story. Keep in mind that all trends end and so will the one you are following. Remember that good stories and good companies are not necessarily good investments. Bad companies can be good investments if they are priced right and there is a catalyst for improvement. A little investor discipline can go a long way to combating the impact that your emotions have on your investments. By focusing on the data first and the story second you can go a long way to avoiding the pitfalls that sink most investor's portfolios.
StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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