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MAKING CENTS OUT OF THE NEWS
Blog #31
(August 13th, 2009)
THE HIGH COST OF HIGH HORSE INVESTING
By Tom McAllister, CFP®
I remember Grandma warning us to "get off our high horses and get back to reality". She was apparently a pioneer in her thinking. Today there's an entire field of economic study called "behavioral finance", based on just the sort of cautions Grandma offered back then. In fact, Israeli psychologist Daniel Kahneman was awarded the 2002 Nobel Prize in economics for his contributions to the behavioral finance movement.
Perhaps my memories of grandparental admonitions explain why the topic of investor behavior so fascinates me. Several years ago, I wrote a newsletter about Kahneman's theories, and those reflections evolved into a talk which I deliver each time I am a guest lecturer on cruise ships. So, in this blog, allow me to point out several errors that can prove costly to investors.
Problems often stem from nothing more complex than overconfidence in one’s knowledge and abilities. Certainly investing is not the only arena in which we see adverse outcomes caused by over-confidence. For example, when drivers were surveyed, 95% expressed the opinion that they are "better than average" drivers. This conclusion is as impossible, of course, as the belief that all the children in Lake Woebegone are above average!
Throughout my forty-seven year investment career I have noted investors' tendency to overestimate their personal investment knowledge. At the risk of being accused of gender bias, I must point out that this phenomenon is particularly common among men. (Many women tend to the opposite extreme of over-caution and fear of risk of any degree, wanting complete safety coupled with handsome investment returns.) Investment professionals who survive long term, in contrast to each of these extremes, recognize the risks they are taking, are willing to admit mistakes, and get out of positions in timely fashion.
"High horse thinking" is common among "day traders", who imagine that, by nimbly jumping in and out of stocks on a daily, weekly, or monthly basis, they can beat the market. Research has disclosed there is an inverse correlation between the frequency and volume of trading and investor returns. Ironically, behavioral finance demonstrates, the more trading you do, the lower your chances of long term success. While one of the explanations for this perverse result is that commissions and "spreads" (markups) often cause net losses, it is misguided over-confidence that is the true villain. Conclusion: “Over-trading can be dangerous to your wealth.”
Along these same lines, it’s not uncommon to see corporate executives with the bulk of their net worth tied up in the shares of their employer company and in other companies in the same industry. These executives often believe their unique vantage point and industry knowledge give them an investing "edge". When their firm - or even the entire industry - goes "off a cliff", as happened in banking and financial stocks in the last year, their portfolio values are decimated. Their "superior knowledge" and "high horse" thinking caused them to ignore the big picture.
"Herd mentality" is another manifestation of over-confidence. As I remarked in an earlier blog post, "Herding behavior still leads in only one direction - investment bubbles." As the public adopts each new "Big Thing", investors' over-confidence is falsely bolstered by the seeing others investing in the same thing, and by a sense of urgency buoyed by a rush to "get in early".
Grandma had never heard the terms "herd mentality", "investment bubble", or "day trading", nor did she live in our time of financial media marketing of do-it-yourself trading. Yet Grandma, I believe, was a pioneer of behavioral finance. What she'd say to today's investors, I imagine, is what she always said to us children - "Get off your high horse!"
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