Common Sense, Comfort Level, and Investor Behavior

Excerpted from The Single Best Investment
Common Sense
No investor can hope to succeed without having the ability to stick to a plan. This is decisively true in the often surprising and dramatic world of investing. You can’t let your convictions be shaken, or you’ll jump from pillar to post the moment times become difficult and, in the end, have little to show for it. Yet only if you’re comfortable with what you’re doing will you be able to stick to your plan. And comfort (peace within and a cool head) in the frequently volatile world of investments is only achieved, I believe, when you are able to stand on the calm bedrock of common sense.

Common Sense

Common sense in investing means employing a strategy that’s inextricably linked to the actual corporations in which you’ve invested. Investing is about being a partial owner of a real business; this fact should never be forgotten, and I’m sure I’ll repeat it until you’re totally annoyed.

Common sense means your strategy needs to be effective in virtually all market conditions (it may shine in some types of markets and be just okay in others, but it should never contain the seeds of even short-term catastrophe, if you’re to maintain a calm mind as a strong holder).

Common sense means having reasonable, achievable goals. Common sense means never trying to hit a home run, and never berating yourself with remorse for a situation that doesn’t work out. Common sense means spreading out your risks, but not so much that you lose control over your portfolio.

Comfort Level
The instant you deviate from a common-sense approach, falling under the sway of a newsletter guru or a slick TV expert, or playing some “system” that’s had a good record for a few years, you’ll lose your comfort level because you’re no longer grounded in the reality of being a part-owner of a real business.

And when you lose your comfort level you become fearful, greedy, superstitious, “intuitive,” prayerful, victimized—you enter into all the emotional states that ultimately provoke investing mistakes.

In the first edition of this book we noted a Morningstar study showed that five-year returns for the average growth fund during the period ended December 31, 1995, were 12%. But average investor returns were only 2.5%. Why the difference? The fund may have been fine, but most investors, apparently, were buying at the tops and selling at the lows. Assets flowed into the funds after they’d had great years—prompting “the crowd” to jump aboard the shiny train—and flowed right back out when the previous pace could not be sustained. Ironically, “average” investors were most comfortable investing when the funds were highest, and least comfortable investing when the funds were cheapest. A recent study by Dalbar Associates confirms the eternal nature of this phenomenon. For the twenty years through 2004 (ten years later than the Morningstar study) the average fund investor earned 3.5%, compared with a market gain of 13%. The facts remain the same—even the spread difference between potential and actual remains the same—though the time periods measured were quite different.

One element present here—an element whose appearance in your own brain you should watch out for—is the natural tendency of the mind to extrapolate from the present. Remember when oil prices were rising in the late seventies? The experts extrapolated the rate of change and decided that by 1990 oil would sell for $100 a barrel. Well, by 1998 they were down to $16 per barrel. Oops. In 1990 journalists were trying to paint a picture of the world’s population totally decimated by AIDS within the decade. Many trends in society seem as if they’re going to last forever, and the mind begins to extrapolate from here to there: but it’s so busy extrapolating it forgets to think of all the things that could change the course of events. The failures that become successes, the successes that become failures. I keep an 8-track tape player in my basement to remind me that things don’t always go as anticipated.

Investors are plagued by doubts and uncertainties, even when things are going well (Should I sell now or wait for even more gains?). This is only natural, for the future is always ineffable, and in the unfolding future the market marks itself by price changes. Unlike other aspects of life, price changes can’t be explained away, or rationalized, or denied. They just are. Prices, and therefore the market, are immutable and beyond our control. I’ll be frank: I’ve never been able to wish a stock to a higher price. Prices make us feel powerless; it’s no wonder that emotional comfort as an investor is hard to achieve.

Investor Behavior
In the relatively new field of Behavioral Finance, students of investor behavior have come to some startling conclusions, conclusions that shed all too much light on the mistakes most of us make and the weaknesses most of us have. These scholars and experimenters have quantified what successful investors have known since time began: it’s not the vehicle that crashes, it’s the nut behind the wheel.

After years and years of assuming that the economy and the markets are made up of rational actors making fully informed decisions, economists and finance researchers have finally come to understand that investors are actually human beings filled with hopes and dreams and fear and confusion. In other words, investors exhibit all the human frailties found in every other realm of living. Traits of character don’t magically dissolve away the moment a person begins to act as an investor. A number of traits common to most investors—like extrapolation—have been identified, and we’ll take a moment to look at a few of interest. Bear in mind that these are not other people’s characteristics, they are yours and mine. They are common characteristics, and more than likely they’re affecting you importantly.

1. Duration is as important as magnitude. Years ago Harvard psychology researchers showed that subjects could endure great levels of pain if they knew the pain would be gone in a short time. But if the subjects were made aware that the pain would last a long time, they suffered more and “gave up” much more quickly even if the actual pain level inflicted was quite modest. The financial world saw this phenomenon after the 1987 crash, when investors did cash in their fund shares, though at a much lower level than expected. It all happened so fast, there was really little time to feel anything, much less act. Afterwards, many investors became involved in waiting for their stocks to return to former prices, to get out even. Moderate levels of fund selling continued right on through the rising market of 1988. According to a recent Louis Harris poll, 78% of investors would sell their funds if the market declined 25% or more. The 1987 crash would have met that criteria, but investors didn’t have a chance to feel the pain. Interestingly, that same survey showed that only 20% of investors would consider buying if stocks fell by 25% or more. Does this sound like a population that wants to buy low and sell high?

Investors intent on improving their results will want to keep these facts in mind, and try to behave contrary to the crowd, hard as that may often be. After all, the crowd is only responding to normal human emotions. Remember, duration is crucial. The longer a downtrend persists, the more difficult it will be to buy the lows, but that difficulty is only your susceptibility to the principles of Behavioral Finance. As a downtrend drags on, whether in an individual stock or in the overall market, participants slowly throw in the towel, one by one, as they reach their individual pain thresholds. Eventually almost everyone is bearish—and almost everyone has already sold. It is from this fertile soil that most great rallies begin.

2. Investors don’t want to experience losses. One reason investors are always waiting to get out even is that they don’t like to experience losses, which are a form of pain. In a number of studies, economist Richard Thaler of the University of Chicago found that losing $1 makes investors feel 2 to 2.5 times as bad as winning $1 makes them feel good. A loss appears larger to most people than a gain of equal size. The reason investors wait to “get even” is that as long as they haven’t sold, the loss is merely on paper; it can be, in effect, denied.

But when the loss is actually taken, a discrete event has occurred that cannot be pushed away from the investor’s consciousness. The loss itself makes the investor feel quite literally like a loser, whereas in holding to “get even” the investor can travel a kind of self-deluded heroic route. Amos Tversky of Stanford University commented that “Loss aversion—the greater impact of the downside than the upside—is a fundamental principle of the human pleasure machine.” This is easy to see in real life. Which gives you a stronger emotion: coming home with a new car, or having it smashed up by a drunk driver the next day?

In the realm of investing, the lesson is that most people have difficulty taking losses, and are more risk-averse than they realize or know. This is important for each of us to know. The highest probability is that you and I and anyone we know are in truth risk-averse, no matter what you or I or anyone we know may say. We need to be aware of it, because it has a direct impact on our investment decisions, most of which pretend to be rational but are actually heavily influenced by our character structures. As Frank Campanale, CEO of Smith Barney Consulting Group, put it, “The fears of the client drive the investment process more than the knowledge of the financial adviser.”

For example, loss aversion, according to Meir Statman, professor of finance at Santa Clara University, prompts investors to sell winning stocks too early. The pain of regret is more powerful than greed, he says. Investors with winning positions sell early in order to avoid the imagined regret they will have if they fail to realize the profits that they currently have. This is no academic theory. I’ve sold too early for emotional reasons many times, and I don’t know anyone who hasn’t.

3. People compartmentalize their money issues. Imagine that upon arriving at a Broadway theater you discover you’ve lost your $50 ticket. Would you pay another $50 for another ticket? Now let’s say you arrive at the theater ready to buy a ticket and discover you’ve lost $50 in cash. It should be clear that in both cases you’re out $50. But of subjects questioned only 46% said they’d buy another ticket if they’d lost the first one, while 88% said they’d still buy a ticket if they had just lost the cash. To buy a second ticket “doubles” the cost of the play in the mind of the buyer, while lost cash is in a more abstract compartment of the mind, and hasn’t yet been “invested” in the play.

Likewise, as Richard Thaler has pointed out, most “normal” investors compartmentalize their money in seemingly irrational ways. People tend to be more aggressive with their money when the markets are ebullient—and that’s why the markets become ebullient!—but become cautious when the market sours. Isn’t this just the opposite of buying low and selling high? That’s another reason why investors may hold on to a stock whose prospects have seriously dimmed, waiting to “get out even.” That stock is put into a separate compartment, and stays there even if holding it directly contradicts all of the investor’s stated principles and guidelines. Daniel Kahneman, of Princeton University, suggests that in the compartmentalizing process, “Investors focus on the risk of individual securities. As a result, they tend to fret over the short-term performance of each investment, often leading to excessive trading and bad decisions.” A calm mind will generate better profits than a hot tip, you might say.

4. Investors lack self-control. In an unusual display of common sense for an economist, Richard Thaler points out that in life we eat too much, we have a terrible time kicking old habits, we don’t exercise enough, in general we aren’t able to take control of ourselves as much as we’d like. Why should it be any different when it comes to investing? Why shouldn’t we jump in with both eyes closed just as the market is hitting new highs and we can’t stand holding so much cash anymore? Why shouldn’t we bail out of a well-run mutual fund when it has underperformed the pack, even though we know its style has been out of favor and if we could just hold a bit longer or even buy more it might become a leader again? It’s in our natures to try to be rational, but, in the end, we have a craving to believe others who’ve got a hypnotic or convincing story to tell, or to find impulsive release when we can no longer tolerate either the pain or the pleasure of our positions.

5. Narcissism plays a role. Thaler notes that investors, risk-averse as they may be, are also in some sense overconfident. Even amateur investors somehow believe their opinions are worth more than a cup of coffee, and most investors will continue to buy mutual funds, though most funds underperform, because they persist in believing they can pick winners. No matter what the facts say, investors will “buy” this theory or that, or this star fund manager or that, believing that they are somehow gifted with the ability to make distinctions in a world that is not only volatile, complex, and unpredictable, but is structured to extract fees from investors every time they make a decision. Investors are arrogant and rarely show the humility and respect that the markets deserve. Rather, they’re like the bumpkin who sees a Picasso for the first time and exclaims, “My child could do better than that!” Maybe, maybe…

Open Your Inner Eyes
We could go on and on looking at the conundrums and complications of the hearts and minds of investors, but the brief discussion above should at least alert you to the fact that you’re probably not making the sorts of rational decisions that you may have imagined yourself to be making, or might be capable of making. Much noise from the underworld intervenes. Emotions influence investment decisions like the moon directs the tides, and to succeed over the long term you’ve got to do more than open a brokerage account and keep your records. You’ve got to tune in to who you are, what you want, how you behave in various conditions, the kinds of change you might be capable of and the kinds you are not.

Awareness and control of the inner life is extremely important to successful investment.

This is not just rhetoric or something that applies to “other” investors. It applies to all of us, and it’s what makes markets volatile in the first place. To tell the truth, investors are flying off the handle everywhere you look.

When anxiety becomes intolerable we tend to believe that we can do something to alleviate the feelings of fear, of loss, of lack of control. More often than not, and nearly always when an investment strategy has been carefully considered in the first place, doing nothing would be the best decision any investor can make. But few are capable of riding comfortably with the waves. Most try to make a break for it and swim, but the shore is far, far away…always farther than it appears. Instead of returns on capital, many investors experience only frustration and bitterness.

Yet investing can be solid and comfortable, like a well-made old wool blanket, if you approach it sensibly. Part and parcel of a sensible approach, a commonsense approach, is to understand just who you are and the kinds of emotional reactions to investing that you experience—as well as how those reactions influence your decisions.

Investors need to learn not only the “rules” for identifying a potentially successful investment, but also to ask, “How will I feel when buying it? How will I feel when holding it? How will I feel when selling a loser? How will I feel when selling a winner?” No one can exist in this life without emotions and their power as decision “makers,” so you might as well get to know them.

Most of us believe we can be good investors if only we can learn what “works.” In part that’s true. The strategy you use must be a sound one. But no strategy exists in a vacuum, it is always implemented, for better or worse, by a human being.

Any strategy must take account of the inherent emotionalism of the human mind and heart and, after that accounting, emerge with a process that inspires faith and confidence in the long-term result.