Bad behaviour

 By Guest Blogger Doug Rowat

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“He did that to me twenty times. Then I got smart.”

– WKRP in Cincinnati’s Herb Tarlek

I write frequently on this blog about behavioural investing, which basically means making erroneous investment decisions based on feelings instead of facts. However, I’ve never illustrated how behavioural investing mistakes play out in the real-life everyday thinking of our clients. And, unfortunately, these behavioural biases are often so deeply entrenched that the same mistakes are made repeatedly. So, in order that we learn faster than Herb Tarlek, allow me to introduce our new (hypothetical) Turner Investments client:

Anchoring
Our new client brings on-board a variety of legacy stock positions. He’s very particular about which ones he wants to sell. Mainly, however, he wants to hang on to all of his losing positions and won’t sell them until they’ve recovered and he’s earned a profit. Anchoring occurs when investors allow a specific piece of information to control all of their investment decisions. In this case, the client has become anchored to his purchase price. Purchase price is irrelevant if the company or sector outlook is poor. Why hold an energy stock, for example, if the oil market looks unfavourable? Hanging on to a position just because you can’t bear the feeling of realizing a loss is irrational (anchoring, in fact, is often closely related to loss aversion—another behavioural investing error).

Familiarity
The client has also been working for a large, publicly traded company for more than 10 years. He’s accumulated a great deal of stock, which now makes up more than 30% of his overall portfolio. He absolutely refuses to sell this position: “it’s a good, well-run company”. Well, unless he works on the board of directors or is the CEO, this is simply a false assumption. Countless employees no doubt thought Enron, Bear Stearns, Nortel or Research In Motion were well run also.

Generally speaking, participating in employee stock-purchase plans are a good idea because of the employer matching and/or strike-price discounts, but concentration risk is the problem. And risk has also been doubled: if the share price declines, not only is the client’s investment diminishing but probably his job security is as well. Familiar or “local” investments are not safer. This is one reason why we maintain broad-based global exposure in all our client portfolios.

Recency bias
We’re now ready to build our new client’s portfolio to our recommended model, but he has some hesitation regarding investing in the US market because it’s performed poorly over the past couple of days. Investors tend to believe that what’s happened recently will continue to happen. But recent events or trends shouldn’t be given disproportionate weight in investment decision making. The long-term trends and fundamentals are far more important. We can’t time markets over the short term and, historically, the odds of the S&P 500, as an example, recording an annualized positive gain over 10 years are impressively about 90%. Our objective is to get the portfolio built and then focus on the long term. Recency bias also often occurs after sensational news days (the Brexit vote or a terrorist attack, for example). While such singular events FEEL like they have enormous consequence, typically they don’t.

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Now, once the portfolio has been built and the client has been with us for a time we often see these two behavioural investing mistakes emerge:

Self-attribution bias
Unfortunately, we weren’t able to convince the client to reduce his exposure to that company stock and, as it happens, the stock has done well. Naturally, we’re pleased for the client; however, the danger comes when investors attribute the successful outcome solely to their own actions or insight and don’t consider the possibility that it could have been a complete stroke of luck. Perhaps the positive performance was due to a strategic takeover. Here investors have to be honest with themselves—did they actually predict that particular takeover? And, unfortunately, the positive performance has probably only further obscured the concentration risk. Also, is the client being honest regarding his OVERALL track record with stock picks? If that record has been so outstanding then why is he paying us a portfolio management fee?

Hindsight bias
At the end of the first year, the client notices that his TFSA has performed much better than his other accounts. Generally, we position TFSAs more aggressively and towards equities because the capital gains aren’t taxed. I explain that equity markets have performed well and that his TFSA has benefitted. The client then questions why all of his accounts weren’t built this way. Hindsight bias, summed up nicely by Investopedia, “leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious whereas, in fact, the event could not have been reasonably predicted.” It’s the equivalent of Monday-morning quarterbacking a portfolio. Naturally, we don’t know for certain that equities will outperform in any given year hence why we also maintain safer assets such as bonds. Inclusion of these defensive assets controls risk and allows us to limit downside when our outlook is incorrect.

I don’t highlight all of the above behavioural investing mistakes to suggest that our client is being unreasonable; after all, we’re only aware of these mistakes because we’ve made them ourselves. Remember WKRP in Cincinnati? We’ve made the error of throwing turkeys to their death from a helicopter so you don’t have to.

But, as God as our witness, we thought they could fly.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.