The ABCs of Behavioral Biases – Intro
By now, you’ve probably heard the news: Your own behavioral biases are often the greatest threat to your financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done.
Why Do We Have Behavioral Biases?
Most of the behavioral biases that influence your investment decisions come from myriad mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives.
Usually (but not always!) these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.
What Do They Do To Us?
As we’ll cover in this series, those same survival-driven instincts that are otherwise so helpful can turn deadly in investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done.
Friend or foe, behavioral biases are a formidable force. Even once you know they’re there, you’ll probably still experience them. It’s what your brain does with the chemically induced instincts that fire off in your head long before your higher functions kick in. They trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petrie dish of financially pathologic behavior,” including:
- Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
- Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
- Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.
What Can We Do About Them?
In this multi-part “ABCs of Behavioral Biases,” we’ll offer an alphabetic introduction to investors’ most damaging behavioral biases, so you can more readily recognize and defend against them the next time they’re happening to you.
Here are a few additional ways you can defend against the behaviorally biased enemy within:
Anchor your investing in a solid plan – By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.
Increase your understanding – Don’t just take our word for it. Here is an entertaining and informative library on the fascinating relationship between your mind and your money:
- “Predictably Irrational,” Dan Ariely
- “Why Smart People Make Big Money Mistakes,” Gary Belsky, Thomas Gilovich
- “Stumbling on Happiness,” Daniel Gilbert
- “Thinking, Fast and Slow,” Daniel Kahneman
- “The Undoing Project,” Michael Lewis
- “Nudge,” Richard Thaler, Cass Sunstein
- “Your Money & Your Brain,” Jason Zweig
Don’t go it alone – Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases. Having an objective advisor well-versed in behavioral finance, dedicated to serving your highest financial interests, and unafraid to show you what you cannot see for yourself is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
As you learn and explore, we hope you’ll discover: You may be unable to prevent your behavioral biases from staging attacks on your financial resolve. But, forewarned is forearmed. You stand a much better chance of thwarting them once you know they’re there!
In our next piece, we’ll begin our A–Z introduction to many of the most common behavioral biases.
Joe Occhipinti is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information posted here represents his opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.
Complimentary Notary Services for Clients
- Veronica Torres – Client Service Associate and Notary Public
At Warren Street Wealth Advisors, we place a heavy emphasis on continuing education and increasing service offerings for our clients.
Today, we would like to congratulate Veronica Torres on becoming a Notary Public of the state of California, and with the event of her passing, we would like to offer complimentary Notary Public services to all of our clients here at Warren Street.
As we continue to grow as a company, we hope to continue our dedication to increasing our knowledge and service offering to our clients.
Contact Us if you have any questions on our Notary services here at Warren Street.
Marketing the Safety Out of It
A growing theme in investing is to target and invest only in the least volatile stocks in the market. One simple example of this is take the S&P500, which is a representation of the 500 largest publicly traded stocks in the United States, and only invest in the 10% of companies with the lowest standard deviation of the 500. This would produce names such as AT&T, Coca-Cola, and Johnson & Johnson.
This simple concept traditionally would result in an investor owning a lot more safety, blue chip, and high dividend yielding stocks. Not a bad bet in a historic context. Looking forward however, we have an accelerating concern over the price of these types of companies, which may lead to them not being as safe as one would expect.
One metric we look at to value stocks is the Price to Earnings ratio, the easiest way to describe this is what price is an investor willing to pay for every dollar a company earns in profit? A higher P/E ratio implies more expensive, a lower one implies cheap. Comparing a stock, or an index, such as the S&P500 to its historical average P/E can give you a relative idea of whether something is expensive or cheap compared to historical standards.
Historically, going back to 1972, the companies in the lowest 10% volatility bucket in the S&P500 (as measured by standard deviation) produce a historical median P/E ratio of roughly 13. As is stands today that same low volatility class of stocks trades between a P/E ratio of 23 to 24.
Chart provided by Ned Davis Research, Inc.
Why is this troubling? Well, when prices revert to the mean, and investors are willing to pay less for those same dollars of earnings, it spells trouble for those who hold these assets, especially those who have been chasing the stability and dividends these stocks were expected to provide.
What is causing this? Let’s take a look at the major contributors:
Fed policy. While artificially low interest rate policy is intended to push investors into riskier assets, some investors still want safer assets. Low volatility stocks have higher dividend yields, making them bond proxies.
Sector attribution. The low volatility group is concentrated in Utilities, Financials, and Consumer Staples, which have high dividend yields and P/E ratios that are above their long-term averages.
High valuations for the broad market. The median P/E for the S&P 500 is 24.0, well above its historical norm, which has pushed investors into “safer” stocks.
Secular trends. Fear is a stronger emotion than greed, so investors have flocked to “safer” assets.
Industry innovation. ETFs have enabled investors to more easily buy themes like low volatility.
The first three factors are the most likely the first ones to threaten this crowded trade. The one that has me the most troubled is the fifth factor. Industry innovation has led to specialized investment products that make it very simple for retail investors to buy into this wave of low or minimum volatility assets. We’re seeing these assets recommended in droves to competitor’s clients, with little to no consideration given to how crowded or expensive the trade may be.
These assets in the broad context of a well diversified portfolio may make sense, but from my perspective every asset has a time and a place. Currently, I would not be overpaying for safety by using these low volatility factors we’ve explored above. There are other ways. Like always, when assets deviate from a historical valuation range, it can take quite awhile to be proven right and see them correct. We’re not yelling fire in a crowded theater but would like to see investors better educated on the risks ahead.
Thank you for reading!
Written by: Blake Street, CFA®, CFP®, Chief Investment Officer
Blake Street is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information posted here represents his opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.