Psychology and Investing: Mental Accounting and Framing Effect

Most of us separate our money into buckets - this money is for the kids' college education, this money is for our retirement, this money is for the house.   Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behaviour.

• Earmarking money for retirement may prevent us from spending it frivolously.

Mental accounting becomes a problem, though, when we categorize our funds without looking at the big picture.

• While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously.  
• Since tax refunds are in fact our earned income, they should not be considered this way.
• For gamblers, this effect can be referred to as "house money."

We are much more likely to take risks with house money than with our own.

• There is a perception that the money isn't really ours and wasn't earned, so it is okay to take more risks with it.  
• This is risk we would be unlikely to take if we would spent time working for that money ourselves.

In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance or realized capital gains.




Framing Effect

This is one other form of mental accounting.

The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect decision.





Overcoming Mental Accounting.

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments.

Take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.

Psychology and Investing: Confirmation Bias and Hindsight Bias

Confirmation Bias

How do we look at information?

Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favourably.

If we have purchased a certain stock in a certain sector, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.


Hindsight Bias

This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome.

Our judgment of a previous decision becomes biased to accommodate the new information. 

For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. 

This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.

Psychology and Investing: Anchoring

When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring.

They get anchored on their own estimates of a company's earnings, or on last year's earnings.

For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it.

We may cling to sub-par companies for years, rather than dumping them and getting on with our investment life.

It is costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.



Overcoming Anchoring

It may be helpful to ask yourself the following questions about your stocks:

Would I buy this investment again?

And if not, why do I continue to own it?

Truthfully answering these questions can help you severe the anchors that may be a drag on your rational decision making.

Psychology and Investing: Sunk Costs

Sunk cost fallacy is another factor driving loss aversion.

This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate the situation on its own merits.

Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses.    

[?Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.]

Psychology and Investing: Loss Aversion

Loss Aversion

Many investors will focus obsessively on one investment that is losing money, even if the rest of their portfolio is in the black.  This behaviour is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers.

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other since reason." (Philip Fisher, Common Stocks and Uncommon Profits).

Regret also comes into play with loss aversion.

This may lead us to be unable to distinguish between a bad decision and a bad outcome.

"We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons.  In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more."

We tend to feel the pain of a loss more strongly than we do the pleasure of a gain. 

It is this unwillingness to accept the pain EARLY that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.

Psychology and Investing: Self-handicapping

Self-handicapping bias occurs when we try t o explain any possible future poor performance with a reason that may or may not be true.

This behaviour could be considered the opposite of overconfidence.

As investors, we may also succumb to self handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected.

Both overconfidence and self-handicapping behaviours are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.

Psychology and Investing: Selective Memory, Cognitive dissonance and Representativeness

Selective Memory

Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing.

In terms of investments we certainly don't want to remember those stock calls that we missed (had I only bought eBay in 1998), much less those that proved to be mistakes which ended in losses.

Such memories threaten our self-image.



Cognitive dissonance

How can we be such good investors if we made those mistakes in the past?

Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.

Incorporating information in this way is a form of correcting for cognitive dissonance, as well-known theory in psychology.

Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviours, at once, and our psyche will somehow need to correct for this.

"Perhaps it really wasn't such a bad decision selling that stock?"

"Perhaps, we didn't lose as much money as we thought?"

Over time, our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.



Representativeness

Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence - such as short-term performance numbers - and too little weight to the evidence from the more distant past.  As a result, we will give too little weight to the real odds of an event happening.

Psychology and Investing: Overconfidence

Overconfidence refers to our boundless ability as human beings to think that we are smarter or more capable than we really are.

Such optimism isn't always bad.  Certainly we would have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts us as investors when we believe that we are better able to spot the next Microsoft than another investor is.  Odds are, we are not.

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade.  Trading rapidly costs plenty and rarely rewards the effort.  Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns.  These frictional costs will always drag returns down.

One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control.  Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.

What Matters and What Doesn't

It is very easy for new stock investors to get started on the wrong track by focusing only on

• the mechanics of trading or 
• the overall direction of the market.

To get yourself in the proper mind-set, tune out the noise and focus on studying individual businesses and their ability to create future profits.

Begin to build the skills you will need to become a successful buyer of businesses.



1.  Investing does not equal trading

Investing is like a chess game, where thought, patience, and the ability to peer into the future are rewarded.

Making the right moves is much more important than moving quickly.



2.  Investing means owning businesses

If you are buying businesses, it makes sense to think like a business owner. 

This means

• learning how to read financial statements, 
• considering how companies actually make money, 
• spotting trends, and 
• figuring out which businesses have the best competitive positions.  

It also means coming up with appropriate prices to pay for the businesses you want to buy. 

Notice that none of this requires lightning-fast reflexes.

You should also buy stocks like you would any other large purchase:  with lots of research, care and the intention to hold as long as it makes sense.

Investing is an intellectual exercise, but one that can have a large payoff.



3.   You buy stocks, not the market

One thing to remember when listening to market premonitions is that stock investing is about buying individual stocks, not the market as a whole.

If you pick the right stocks, you can make money no matter what the broader market does.

Another reason to heavily discount what the prognosticators say is that correctly predicting market movements is nearly impossible.

• No one has done it consistently and accurately.  
• There are just too ma y moving parts, and too many unknowns.

By limiting the field to individual businesses of interest, you can focus on what you can actually own while dramatically cutting down on the unknowns.  

You can save a lot of energy by simply tuning out market predictions.

With so many predictions about the stock market floating around, simple statistics says there are bound to be a handful of them that come true.  When thinking about this, it is helpful to remember the saying: "A broken clock is correct twice a day."

Stocks are volatile.  Why is that?  Does the value of any given business really change up to 50% year-to-year?   "Mr. Market" tends to be a bit of an extremist in the short term, overreacting to both good and bad news.



4.  Competitive Positioning is most important

Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate those future earnings.

Competitive positioning or the ability of a business to keep competitors at bay, is the most important determinant factor of future profits.

Competitive positioning is

• more important than the economic outlook,
• more important than the near-term flows of news that jostles stock prices and 
• even more important than management quality at a company.

Time is a precious resource in investing.

Business economics trump management skill.

A company with the best competitive positioning is going to create the most value for its shareholders.




Summary:


Active traders have three things working against them:  the bid/ask spread, commissions and taxes.

Stocks are not just pieces of paper to be traded; they are pieces of businesses.

The stock market as a whole is nearly impossible to predict, but predicting the outcome of individual businesses is a more manageable exercise.

Mr. Market is highly temperamental, over-reacting to both good and bad news.

Future profits drive stock prices over the long term, and the competitive positioning of a business is the most important factor in its ability to generate future earnings.

My Golden Rule of Investing

My Golden Rule of Investing: 
Companies that grow revenues and earnings will see share prices grow over time.

• Over the long term, when companies perform well, their shares will do so too.  
• When a company's business suffers, the stock will also suffer.

For examples:

Starbucks has had phenomenal success at turning coffee - a simple product that used to be practically given away - into a premium product that people are willing to pay up for.  Starbucks has enjoyed handsome growth in number of stores, profits and share price.  Starbucks also has a respectable return on capital of near 11% today.

Meanwhile, Sears has languished.  It has had a difficult time competing with discount stores and strip malls, and it has not enjoyed any meaningful profit growth in years.  Plus, its return on capital rarely tops 5%.  As a result, it stock has bounced around without really going anywhere in decades.




Over the long term

Over the long term, when a company does well, your interest in that company will also do well.

Stocks are ownership interests in companies.  Being a stockholder is being a partial owner of a company.

Over the long term, a company's business performance and its share price will converge.

The market rewards companies that earn high returns on capital over a long period.

Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital.

The wealth a company creates - as measured by returns on capital - will find its way to shareholders over the long term in the form of dividends or stock appreciation.

The market frequently forgets the important relationship between Return on Capital and Return on Stock

Return on Capital

Return on capital is a measure of a company's profitability.

                Return on Capital = Profit / Invested Capital


Return on Stock

Return on stock represents a combination of dividends and increases in the stock price (capital gains).

                Stockholder Total Return = Capital Gains + Dividends




The important relationship between Return on Capital and Return on Stock

The market frequently forgets the important relationship between return on capital and return on stock.

A company can earn a high return on capital, but the shareholders could still suffer if the market price of the stock decreases over the same period.

Similarly, a terrible company with a low return on capital may see its stock price increase

• if the firm performed less terribly than the market had expected, or,  
• maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.

Short run

In the short term, there can be a disconnect between

• how a company performs and 
• how its stock performs.

This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create.

Sometimes this perception is spot on; sometimes it is way off the mark.



Long run

But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.




The Voting and Weighing Machines

The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine - tallying which firms are popular and unpopular.  But in the long run, the market is like a weighing machine - assessing the substance of a company.




Message

What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.

Why Stocks Perform the Best

Why, exactly, have stocks been the best-performing asset class?

Why should we expect those types of returns to continue?

Why should we expect history to repeat?



Answers

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value.

Stock investors have full exposure to this upside.

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses.

More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Bond investors do  not reap the benefit of economic expansion to nearly as large a degree. 

When you buy a bond, the interest rate on the original investment will never increase. 




Microsoft in 1985:  Buy its bonds or its stocks?

For instance, in 1985,

• would you have rather lent Microsoft money at a 6% interest rate, or 
• would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did.

Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

It is important to have a long-term investment horizon when getting started in stocks.

Time is on Your Side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be.

With time,

• your chances of making money increases, and 
• the volatility of your returns decreases.

The Longer you invest, the Lower the Volatility of your Returns

The average annual return for the S&P 500 stock index for a single year has ranged from -39% to +61%, while averaging 13.2%.

After holding stocks for 5 years, average annualised returns have ranged from -4% to +30%, while averaging 11.9%.

If your holding period is 20 years, you never lost money, with 20-year returns ranging from +6.4% to +15%, with the average being 9.5%.


These returns easily surpass those you can get from any of the other major types of investments.




The Importance of having a Long-term Investment Horizon in Stocks

Again, as your holding period increases,

• the expected return variation decreases, and 
• the likelihood for a positive return increases.  

This is why it is important to have a long-term investment horizon when getting started in stocks.





Summary


While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term.


We do not recommend that you invest in stocks to achieve your short-term goals.


To be effective, you should invest in stocks only to meet long-term objectives that are at least 5 years away.


The longer you invest, the greater your chances of achieving the types of returns that make investing in stocks worthwhile.




Additional notes:

Though stocks typically perform best over the long term, there can be extended periods of poor performance.  

For example, the DJIA peaked in 1966 and didn't surpass its old high again until 16 years later in 1982.  But the following 20 years were great for stocks, with the Dow increasing more than tenfold (10x) by 2002.

Volatility of the Stock Market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio.

However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly.

• You may experience large losses over short periods.
• Market dips, sometimes significant, are simply part of investing in stocks.

Yearly Market Fluctuations

The yearly returns in the stock market also fluctuate dramatically.  

The highest one-year rate of return of +67% occurred in 1933, while the lowest one-year rate of return of -53% occurred in 1931. 

It should be obvious by now that stocks are volatile, and there is significant risk if you CANNOT RIDE OUT MARKET LOSSES IN THE SHORT TERM.




The Bright Side of this Story

But don't worry; there is a bright side to this story.

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type.  

This is an incredibly important fact!

• When the stock market has crashed, the market has always rebounded and gone on to new highs. 
• Stocks have outperformed bonds on a total real return (after inflation) basis, on average.  

This holds true even after market peaks.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills.

In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of investing in stocks.

• Even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash.
• Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Volatility of Single Stocks

Volatility of Single Stocks

Individual stocks tend to have highly volatile prices.

The returns you might receive on any single stock may vary wildly.



Best Performing Stocks

If you invest in the right stock, you could make bundles of money.

• For instance, Eaton Vance, an investment-management company, has had the best-performing stock for almost 25 years.  If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.

Worst Performing Stocks

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment.

• There are hundreds of dot-com investments that went bankrupt or are trading for a fraction of their former highs in early 2000.

• Even established, well-known companies such as Enron, WorldCom and Kmart filed for bankruptcy and investors in these companies lost everything.

All Stocks in Between these two Extremes

Between these two extremes is the daily, weekly, monthly and yearly fluctuation of any given company's stock price.

• Most stocks won't double in the coming year, nor will many go to zero.

• But the average difference between the yearly high and low stock prices of the typical stock on the NYSE is nearly 40%.

Stocks that don't perform over Long Time

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time. 

• In 1965, you could have purchased General Motors' stock for $50 per share (split adjusted).  By May 2005 (4 decades later), your shares of General Motors would be worth only about $30 each.  Though dividends would have provided some ease to the pain, General Motors' return has been terrible.  
• You would have been better off if you had invested your money in a bank savings account instead of General Motors' stock.

All your Eggs in a Single Basket

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs.

Other times, that basket will hold the equivalent of a winning lottery ticket.

With compound interest, the last few years of compounding make the most difference.

The 3 components that determine how much money you will have in the future are:

1.  the amount of money invested,
2.  the length of time invested, and
3.  the rate of return.

The earlier you invest, the more you invest, and the higher the rate of return, the more money you will have in the future.

The primary attraction to investing in stocks is that the long-run rate of return is higher than the interest earned in bank accounts or bonds.

With compound interest, the last few years of compounding make the most difference.




Additional notes:

The rule of 72 is an easy rule of thumb that tells you how often your money doubles.  Divide 72 by the percentage rate of return to determine the number of years required for your money to double at that rate of return.

Why Invest in Stocks?

Why stocks?

Stocks are but one of many possible ways to invest your hard-earned money.

Why choose stocks instead of other options, such as bonds, real estates, bank savings accounts, rare coins, or antique sports cars?

The reason that savvy investors invest in stocks is that they provide the highest potential returns.

Over the long term, no other type of investment tends to perform better.



Downside

On the downside, stocks tend to be the most volatile investments.

This means that the value of stocks can drop in the short term.

Sometimes stock prices may fall for a protracted period.

Bad luck or bad timing can easily sink your returns, but you can minimise this by taking a long-term investing approach.



Returns

There is also no guarantee you will actually realize any sort of positive return.

If you have the misfortune of consistently picking stocks that decline in value, you can lose money, even over the long term!



Education

By educating yourself, you can make the risk acceptable relative to your expected reward.

With knowledge, you can pick the right businesses to own and to spot the ones to avoid.

This effort is well worth it, because over the long haul, your money can work harder for you in equities than in just about any other investments.








Additional notes:

A slightly higher return in your investments can lead to dramatically larger dollar sums for whatever your financial goals in life may be,

Investing in stocks is an intellectual exercise and requires effort, but it is an effort that can bear many fruits.

Among the potential investments one can make, stocks provide the largest long-term returns, but they also have the largest volatility.

Stocks are ownership interests in companies.  They are not simply pieces of paper to be traded.

Understanding Your Circle of Competence

If Buffett cannot understand a company's business, then it lies beyond his circle of competence and he won't attempt to value it.

He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology.

On the other hand, Buffett continued to buy and hold what he knew.

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong.

Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) buy simply avoiding big mistakes.

He believes that what counts most for investors is not so much what they know but how realistically they can define what they don't know.

Concentrating on Your Best Ideas

Buffett has difficulty finding understandable businesses with sustainable competitive advantages and excellent managers that also sell at discount to their estimated fair values.

Therefore, his investment portfolio has often been concentrated in relatively few companies.

Buffett rejects the idea that diversification is helpful for the INFORMED investors.

On the contrary, he thinks the addition of an investor's 20th favourite holding is likely to lower returns and increase risk compared with simply adding the same amount of money to the investor's top choices.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Successful investing is hard, but it doesn't require genius.

Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Behavioural finance attempts to explain why people make financial decisions that are contrary to their own interests.

Behavioural finance has a lot to offer in terms of understanding psychology and the behaviour of investors, particularly the mistakes that they make.  

Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behaviour might move the market.

We can also focus on how the insights from the field of behavioural finance can benefit individual investors.  Primarily, we are interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.


Some insights one can focus on in behaviour finance are:

• Overconfidence
• Selective Memory
• Self-Handicapping
• Loss Aversion
• Sunk Costs
• Anchoring
• Confirmation Bias
• Mental Accounting
• Framing Effect
• Herding