Investing vs. Behavior

A Tale of Behavioral Instincts

As investors, we are consistently at odds with our pre-programmed human behavior. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their impulsive, often damaging gut reactions to breaking news. Once we complete our exploration of market return factors, we’ll explore the fascinating field of behavioral finance in more detail, as this “human factor” contributes significantly to your ultimate success or failure as an evidence-based investor.


Carl Richards Behavior Gap

 

 

 

 

 

 

 

 

 

 

 

In our last piece, “Investing Seeking the Future” we wrapped up our conversation about ways to employ stock and bond markets within a disciplined investment strategy. We now turn to the final and arguably most significant factor in an evidence-based investment strategy: the human factor. In short, impulsive/ behavioral reactions to market events can easily outweigh any other market challenges you face.

 

Exploring the Human Factor 

Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated instincts and emotions that spur us to leap long before we have time to look.

 

Rapid reflexes often serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think; his or her laughter elicits an instant outpouring of love (and oxytocin).

 

But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by ill-placed, “survival of the fittest” reactions.

 

Put another way by neurologist and financial theorist William J. Bernstein, MD, PhD, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”

 

 

Behavioral Finance, Human Finance

To study the relationships between our heads and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens?

 

Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors themselves as well as what is happening inside our heads to generate them. To name a couple of the most obvious examples:

 

  • When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to “Sell!”
  • When markets unexpectedly soar – Your brain’s reflexive nucleus accumbens fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to seize the day. “Buy!”

 

An Advisor’s Greatest Role: Managing the Human Factor

Beyond such market-timing instincts that lead you astray, your brain cooks up plenty of other insidious biases to overly influence your investment activities. To name a few, there’s confirmation bias, hindsight bias, recency, overconfidence, loss aversion, sunken costs and herd mentality.

 

 

Your Take-Home

Managing the human factor in investing is another way an evidence-based approach helps to guide us- using data driven methodology instead of emotion.  By spotting when we (as investors) are falling prey to a behavioral bias, it is possible to overcome emotional decision making and implement a strategy based on rational observations.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Image Attribution: Carl Richards (c) 2013 Behavior Gap

What Gives You Control?

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Which of the following do you have more control over?

  1. Timing the market’s ups and downs
  1. Staying Invested and Staying Disciplined

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You missed 1 day out of over 11,000, so what?

Above is a graphic that shows how reacting to market conditions (and/or attempting to time the market’s ups and downs) would change your return as an investor.  This example uses the Performance in the S&P 500 between 1970-2015 (that’s over 11,000 market days).  The annualized compound  return for the entire period was 10.27%.  If you had missed the single best day in the market during that time, your annualized compound return would be 10.01%.  In dollar terms, if you had invested $1,000 at the beginning of the period and received 10.27% annual return, you would end with $89,678.  If you had missed the best single day you would have missed out on $9,308 because your end result would be $80,370.  As a long term investor, that is quite severe a penalty for missing one day –  out of 46 years.

Let’s go a step further and say you missed the best 25 days.  Your annualized compound return would be 6.87%; or $21,224  if you had invested $1,000 at the beginning of the period.  That is a difference of $68,454 because you missed 25 days out of over 11,000.

If You Are an Investor, Then Be an Investor.

As investors, we want to focus on things that we can control.  What is out of your control? Predicting the market’s ups and downs, and letting our emotions determine the timing or frequency of our investments.  What is in your control? Settling on an appropriate mix of investments, investing in them, and staying true to your original objectives – knowing that there will be ups and downs along the way.

 

So instead of answering our original question, we’ll let you be the judge!

 

 

 

Attribution and Disclaimer: Graphic in US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Performance data for January 1970–August 2008 provided by CRSP; performance data for September 2008–December 2015 provided by Bloomberg. S&P data provided by Standard & Poor’s Index Services Group. US bonds and bills data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

The Global Marketplace

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The World At Your Fingertips

As investors, we have the entire global marketplace available to us.  The image above shows the global capital market (the markets available for investment around the world). Like an atlas, the image is laid out loosely in the shape of the continents and countries.  Instead of national borders, however, each country’s outline is based on the size of its capital market relative to the entire global market.   The markets are then identified by their percentage size, and in color by the type of market, developed, emerging, and frontier.  Developed markets are in countries with stable political and economic atmospheres, and have transparent systems for accounting and regulation.  Emerging Markets are in countries that fall short in some way, whether it is the political regime or lack of market transparency.  Frontier Markets fall short in multiple ways, and are generally too risky for individual investment.

 

Capital Markets Vs. Economies

As you view the ‘map’ you will notice the relative size of the United States capital market, and in particular, the relative size of the Chinese market.  While China is the second largest economy (after the United States) by most measures, because of their political structure and their non-transparent systems for accounting and regulation, the actual size of their capital markets is relatively small and emerging.

 

How to Own the Global Market?

As investors, we want to participate in the growth of all of the meaningful global capital markets in approximate proportion to their overall composition (See: Diversification a Complete Meal).  By owning thousands and thousands of different types of companies around the globe through low-cost mutual fund investments, it is possible as an investor to take advantage of the constantly shifting flows of growth in a highly diversified and meaningful way.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Stocks and Bonds: The Fundamentals

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Stocks and Bonds

 

As an investor, it is important to gain an understanding (no matter how generalized) of what you are investing in.  Let’s start with stocks and bonds (and cash).  What are they?

 

Stocks

Stocks are typically ownership shares in a company.  As an owner of a stock, you are technically an owner of the company.  Pause, and let that sink in.  Think about all the stocks you may own (individually or in a mutual fund) and then say to yourself, “I own that company”.

As an owner you accept the many risks that could result.  On the other hand, your expected return for the risk associated with ownership is greater; and you usually get to participate in the earnings of those companies in the meantime.

Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).

 

Bonds

Bonds are a form of debt.  If a company or government needs to raise money, they’ll often ask to borrow it.  Now, pause and let that idea sink in.  If you own a U.S. Treasury bond, for example; you have loaned the government money.

In return for lending money, as an investor you are entitled to an interest rate to make it worth your while.  Because bonds are often secured by property and governed by a specific agreement, they typically are considered less of a risk, and as a result they usually return less over time than compared to stocks.

Bonds are a good tool for dampening that ‘bumpy’ ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.

 

Cash – While we talk about stocks and bonds as the two primary forms of investment, what is your alternative.  Probably cash.  So what is the problem with cash?

Simple, as an investment, in the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re great to have on hand for near-term spending needs.

 

Summary

A simple guide for stocks, bonds, and cash:

  Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth
Bonds (Fixed Income) Lower Preserving wealth
Cash Negative (after inflation) Spending wealth

 

By keeping your attention focused on the larger principles guiding investment in stocks and bonds, it becomes easier to recognize that each type of investment in your overall portfolio serves a specific purpose in your total wealth management plan.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Let Markets Work For You

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Let Markets Work For You

The Market

The ‘Market’ as we refer to it, is the collective embodiment of every person willing to buy or sell something.  In the investment world, the ‘Market’ typically refers the ‘Stock Markets’ where stocks (usually ownership shares of companies) are bought and sold.  Millions upon millions of people participate in the buying and selling of stocks each day around the world.

 

The Mixing Bowl

Every single market participant (investor) has a view of how a stock should be priced, they then act accordingly, either buying, selling, or doing nothing.  The effect this has on the market is that the price of a stock at any given point in time incorporates all the information which the millions of investors have.  The market essentially acts like a mixing bowl; mixing opinions from around the globe into one final product; a price.

 

Your Choice

Your choice as an investor is to either compete and outguess the collective knowledge of all the other investors, or harness the power of their knowledge and embrace the prices set by the market. Let markets work for you.

 

 

For more information see our post: You, The Market, and The Prices You Pay

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

 

Image Attribution: Dimensional Fund Advisors