We see what we want to see We see what we want to see http://www.federatedinvestors.com/texPool/static/images/texpool/texpool-logo-amp.png http://www.federatedinvestors.com/texPool/daf\images\insights\article\heads-brains-small.jpg August 3 2020 July 31 2020

We see what we want to see

Our humanness can trip us up when it comes to investing.
Published July 31 2020

[Editor’s Note: Because my ghost writer and I failed to coordinate vacations, I’m offering a special on Behavioral Finance this week. My regular column will return a week from Friday.]

This is what’s known as Cognitive Dissonance Bias—a predisposition to disregard news that doesn’t fit our world view. Bears, for example, look at today’s situation and see serious headwinds. Record Covid-19 cases with no vaccine in hand. A steep first-half economic contraction and jobless claims plateauing at post-Great Depression highs. An increasingly likely Blue Wave and all the tax increases and renewed regulations that might bring. Bulls, on other hand, see spectacular tailwinds. Unprecedented stimulus—“Don’t fight the Fed” to the max. The best 50-day stock rally in history and rates that are so low there is no alternative to stocks. A consumer who can’t be stopped.

We see what we want to see because of our humanness—we can’t escape our emotions and biases. In their pioneering work on Behavioral Finance, the influence of psychology on individual investment and market behavior, economist/psychologist Daniel Kahneman, 2002 winner of the Nobel Prize for Economics, and psychologist Adam Tversky effectively concluded there is no such thing as a dispassionate investor. A broad range of biases tend to work against optimal returns, even if the individual or the market is aware of them. Some of the most common, and powerful, of these biases have been very much on display in recent months.

  • Sell everything! Indiscriminant selling is driven by Group Think Bias, a belief the crowd must be right so you go along. Unfortunately, lots of times the crowd is wrong. This was clearly illustrated in mid-March, when investors were dumping everything—stocks, Treasuries, even gold, the haven of all haven trades—and going to King Cash. The meltdown threatened broad market functioning, forcing the Fed to step in like it never has before, and locked in losses that, had stock investors simply held on, largely would have been recouped.
  • Got FOMO? Fear of missing out is representative of Herding Bias, the strongest trading bias of them all. It leads investors to buy high and sell low, the exact opposite of what a disciplined, diversified investor should do. Related to Group Bias, this bias has resulted in what arguably is the most crowded trade in modern history, FMAGA stocks (Facebook, Microsoft, Amazon, Google and Apple). The combined weight of these five stocks represents a record 22% of the entire S&P 500 market cap. This trade has been great during the crisis, as big tech has had it both ways, acting as both defensive and momentum stocks. But history tells us that one-way trades never last, leaving the market vulnerable to a very small group of stocks if any of them turn the other way.
  • Big gain, small pleasure This occurs from what Kahneman et al call Myopic Loss Aversion Bias. Their studies found that humans tend to suffer losses at two times the level of joy they experience from gains—one reason investor sentiment has remained bearish despite a market recovery that has been almost as spectacular as March’s waterfall decline. The pandemic’s rapid ascent, and the accompanying speed and magnitude of the late February/March plunge, left many unnerved. Similar shell-shock saw equity fund flows remain flat to negative the first four years after the 2008-09 global financial crisis market bottom, even as large- and small-cap equities were scoring some of their biggest annualized gains during the 11-year cyclical bull market. Indeed, money generally has been leaving equities and flowing into bonds from 2008 until today!
  • This can’t last Regret bias—going to great lengths to avoid the feeling of regret—tends to rear its head during periods of uncertainty, leading traders to sell a winning position too early and a losing position too late. Similar to this and Myopic Loss Aversion Bias is Hot Stove Bias, in which we overweight worst outcomes and act to avoid them at all costs. It was first introduced by Mark Twain, who observed if a cat jumped on a hot stove, she would never jump on the stove again—even if it’s cold. A National Bureau of Economic Research report in 2016 found nervous investors who checked portfolios frequently tended to adopt more conservative strategies that resulted in poorer performance relative to those who checked portfolios less frequently and thus invested in riskier assets that yielded higher returns over time.
  • We are all MMTists now The response to the Covid pandemic has been breathtaking stimulus across the globe—in the U.S. alone, combined Fed and fiscal support to date totals $9.5 trillion, or 44.4% of GDP, with more to come! Modern Monetary Theory, a former fringe movement that argues the level of sovereign debt in a country doesn’t matter as long as there is no inflation, is now part of the mainstream thinking. A lot of this reflects Vividness Bias, which Warren Buffet defines as people underestimating low-probability events if they haven’t happened recently and overstating them when they have. The concern: is this bias causing the government to go too big to fight this crisis, creating moral hazard and racking up huge bills that eventually will be paid?

Looking ahead to the back half of this year, it’s worth remembering that we entered this crisis with high levels of personal savings, record corporate and consumer cash flows, and clean balance sheets. Thanks to the unprecedented stimulus, this really hasn’t changed much despite spring’s shutdowns and shelter-from-home orders. Now we are reopening, albeit choppily, with a critical election on the horizon and a historically challenging period of seasonality underway. There is going to be more volatility and uncertainty.

So knowing and understanding the biases that shape our investment behavior may help us control misguided impulses that can undermine returns. As Warren Buffet explains, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ …. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.’’ This begs for patience. Easier said ….

Tags Equity . Markets/Economy .