Richard Thaler, one of the founding fathers of behavioral finance and the 2017 recipient of the Nobel Memorial Prize in Economics, says: “Conventional economics assumes that people are highly rational — super rational — and unemotional. They can calculate like a computer and have no self-control problems.”
Unfortunately, investors often behave irrationally as a result of cognitive and emotional biases. At Pulliam Family Office, our purpose is to be significant in the financial lives of executives at publicly traded companies — that looks different depending on the market context.
In the middle of 2009, it meant challenging the fallacy that the stock market was going to zero by that December. This year, it means acknowledging that all prices do not go up forever. The context of the market changes — as does the executive’s appetite for results.
I believe the significance that we pursue can be located between executives’ biases and the global capital markets. Let’s look at what I mean.
Emotional and Cognitive Biases
Perhaps you have IBM stock and refuse to believe that the stock you purchased 20 years ago is not the highest and best use of capital. Or maybe you have never sold one single share of an RSU because you believe you have control over your company’s stock performance. These mindsets are what we call investor biases.
A few emotional and cognitive biases you may encounter (or experience yourself) are outlined below:
- Loss-aversion bias: Put simply, loss-aversion bias is a preference for avoiding losses over making gains. Loss-aversion can cause investors to hold on to losers for too long and to sell winners too quickly.
- Regret-aversion bias: Investors exhibiting regret-aversion bias are apt to avoid making decisions out of a fear that their decisions will turn out badly. Regret-aversion can lead to herding behavior — investors may gravitate to investments that are popular because they feel safer among the crowd. If everyone is wrong about a stock, they will feel less personally responsible for making a bad decision.
- Endowment bias: A phenomenon Thaler has studied extensively, endowment bias occurs when investors place a higher value on assets they own (i.e., the price they require to sell a stock they own is higher than the price they would be willing to pay for the same stock). Endowment bias may make investors reluctant to sell certain assets and result in suboptimal asset allocation.
You can read about more emotional biases here.
- Mental accounting bias: This is another bias studied by Thaler. An investor exhibits mental accounting bias by mentally assigning money to different categories or “buckets” and treating it differently based upon that assignment. Mental accounting bias can also result in a suboptimal asset allocation.
- Confirmation bias: This bias occurs when investors seek out and give credence to information that confirms their existing beliefs. Confirmation bias may cause investors to consider only the positive information about an investment and ignore new information that would contradict their investment thesis. Confirmation bias can result in investors not considering all available, relevant information about their investments.
- Hindsight bias: An investor showing hindsight bias will often see past events as having been predictable. Hindsight bias may lead clients to overestimate the extent to which they predicted investment results, causing them to become overconfident.
You can read about more cognitive biases here.
What Is Your Bias?
“History doesn’t repeat itself, but it does rhyme.” —Mark Twain
I believe in challenging the orthodox of Wall Street and increasing your emotional intelligence as an investor. To begin, you need to evaluate whether any of the above biases are making an undue impact on your financial thinking today.
You may be saying, “Why now? My investment accounts have never been higher,” or, “My real estate has never been worth more.” Maybe it’s, “Why now? My company stock is at 52-week highs,” or, “My debt has never been cheaper.” If so, you may be exhibiting symptoms of an underlying bias.
I believe now is the time because I’ve seen this movie before. I remember the tough losses of my career with remarkable clarity (which could be defined as my own hindsight bias). The fact is that none of us are immune.
I encourage you to read Jeremy Grantham’s newsletter titled “It’s Everywhere, In Everything: The First Truly Global Bubble” and supplement that reading with John Hussman’s market comment, “What Triggered the Crash.” Both point to the current U.S. capital market valuations and indicate that the future 10–12-year returns can be cumulatively negative. That journey is probably not a smooth one as history demonstrates.
So, what is the wisdom that I am asking you to draw from this information? Allow me to point out the potholes that I have stepped in before. It’s a lesson that I learned during my leadership years at Merrill Lynch. This is the perfect time to robustly reevaluate everything — things have never been better, just like the years leading up to the Tech Wreck (2000) and the Great Recession (2007).
I’m not talking about a black box of market timing — that is unattainable. I am advocating a pause to take inventory of what matters to you. Align your capital to that purpose. Be cognizant of the biases that come along with all of us humans. Be aware of the current context of global risk markets. Design and execute an updated financial plan with detailed success metrics. Measure results. Adapt.
It all starts by taking 15 minutes to chat with me so we can start identifying and dismantling your biases together.
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