Abnormal Markets
If we can’t stop ourselves being biased by market information then we have the alternative of avoiding it. The idea that we should cut ourselves off from our portfolios and limit our exposure to market news is anathema to the majority of us, but we’d probably end up wealthier as a result.
After all, as I discussed in Maladaptive Investing, most of our psychological biases are the result of normal behavior in an abnormal environment. If you can’t change the former without a million years of adaptation then maybe we should accept the inevitable and turn off the tracker.
In a recent FT piece John Authers notes that some very good fund managers don’t keep track of their purchase prices. This is good psychology – if you don’t know what price you bought at it can’t be a consideration in selling. This eliminates anchoring, loss aversion and the disposition effect at a stroke. After all, what really matters is future performance not some arbitrary past data point.
But I’d go further than this. If anyone feels the absolute need to remember the price they bought a security at then I’d say they’re biased to start with. It’s the wrong mindset for an investor, and it’ll push you into selling stocks you should keep and keeping ones you should sell. That we don’t need to do this is the private investor’s edge over professional traders: we can afford to measure performance over decades, rather than weeks. Or seconds.
Fret Not
Once you take this decision then the next logical step is to only invest in stocks you don’t need to spend hours fretting over. When you can’t track share prices on a minute by minute basis you don’t really want to be invested in some highly risky corporation. Investing in companies with low share price volatility, which are likely to still be around the next time you take a squint at your holdings, becomes essential, and will probably have beneficial consequences as we saw in Low Risks, High Rewards: the Low Volatility Anomaly.
If you shut down the news feeds as well you’re less likely to be exposed to noise traders enthusiastically ramping the latest go-go stock (see: Idiot Noise Traders). While, of course, it’s possible you might happen to alight on the next great company by tracking popular trends it’s not very likely that you’ll stay invested in it for a very long time if you keep on doing so. I've lost count of the conversations I've had with people who explain to me carefully how they buy and sell stocks on a regular basis and then lament the one stock they sold that would have made their fortune: and they never seem get the irony. Or the point.
Myopic Loss Aversion
The classic explanation for the problems we have tracking our portfolios came from Shlomo Benartzi and Richard Thaler in Myopic Loss Aversion and the Equity Premium Puzzle who pointed the finger of blame at myopic loss aversion and mental accounting. Loss aversion is well known – it’s our unwillingness to sell at a loss, no matter how deadbeat the underlying stock. Myopic loss aversion is where our unwillingness to suffer a loss, even on a short term basis, becomes pathological. Here we sell winners to avoid ever having red ink in our portfolio.
This inevitably means people react to any and every piece of news by selling, regardless of the underlying fundamentals. Sufferers from this condition have an information horizon that’s so close they’re in danger of tripping over it, and an evaluation frequency that’s so high they must suffer from whiplash as the stocks whizz in and out of their holdings. The passive approach, on the other hand, requires an evaluation frequency measured in months and an information horizon in years, (I should note here that “information horizon” is, in my view, a bit of a misnomer – it’s probably better known as “investment flexibility”: the freedom of the individual investor to change what they’re invested in).
Over The Information Horizon
Andrew Hardin and Clayton Arlen Looney investigated how these factors interact in Myopic Loss Aversion: Demystifying the Key Factors Influencing Decision Problem Framing. The results are complex but reduce down to a couple of key points. Firstly, longer information horizons promote broader framing – i.e. people think about their portfolios in a more holistic way, rather than worrying about the individual stocks and securities; not surprising if you can’t actually change your investments quickly. This is likely to lead to less biased investing – if only because you can’t react to events by making changes.
The second finding is that:
“Extending the time interval between evaluations or curtailing the rate of decisions produces dramatic shifts in a decision maker’s attitude to risk”.
In fact, the less decisions or frequent evaluations we make, the more inclined we are to accept risk – that is, in the jargon, to tolerate volatility. So if we either inspect our portfolios less often or make fewer decisions we trade less. But the question is, does this lead to better returns?
Trading Sideways
Well, actually that’s not quite the question. Underlying this are issues of personal happiness and the lowering of stress associated with tracking your portfolios all the time. But let’s put those issues aside and focus on the numbers. In Winners and Losers: 401(k) Trading and Portfolio Performance the researchers conclude:
“That those who trade in their accounts seem to earn higher returns before adjusting for risk, but traders fail to outperform after risk adjustment. Also, we find that passive rebalancers perform best (on a risk-adjusted basis): these are investors who hold only balanced or lifecycle funds where their portfolio manager rebalances on their behalf. A passive rebalancer can earn substantially more – over 80 basis points per year – compared to traders and other nontraders.”
That’s quite a subtle finding and means that non-traders do as well as traders, and non-traders who re-balance (periodically sell some winners to invest in some losers) do better, presumably as mean reversion effects kick in. Re-balancing is quite important – 401(k) plans are dominated by inertia, where the default investment choices are never changed. So having a default to re-balance is likely to be extremely beneficial to anyone trying to decide how to manage their investments.
Investing Inertia
Famously Terrence Odean and Brad Barber showed that people moving from standard brokerage accounts to the new-fangled Internet trading traded more, and performed worse (see: The 160 Billion Dollar Bezzle). The implication being that sheer inertia prevented investors from trading by effectively decreasing their rate of decision making. Apparently it’s harder to pick up the phone and talk to someone than it is to press a couple of buttons – although that might say more about most traders’ social skills than it does about their investing ability.
Thaler and Benartzi’s research suggests that you shouldn't look at your portfolio more than once a year. Perhaps the soundest advice is that if you need to peek more often you should probably reconsider your asset allocation. Building a minimal interference portfolio, with periodic re-balancing, is probably the lowest maintenance type of active investing possible.
If you have to look more often then make sure you don’t have access to purchase prices. They’re an unnecessary anchor – it’s hard enough to make even vaguely optimal investing decisions without being weighed down by the burden of our own disposition. You can’t ever take the bias out of the brain, but you can at least remove the brain from some of the sources of the bias.
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