Managed Money Reporter Newsletter — Issue 217, May 2005


Editors: Carl Spiess & Allan McGlade


Featured Articles



Investor Psychology

In the last several months, I have attended several seminars on Behavioral Finance.  We strive to understand the best ways to help clients keep their investments to achieve the best long term returns.  So understanding emotions and the psychology of money, is not just interesting, but essential.

Here are some of the key insights and areas where investors can work to improve their responses to the uncertainty that is investing, as well as some interesting examples.

Extrapolation

Investors extrapolate short term trends, as if they will continue forever.  Forgetting that over the last 10, 20 and 50 years, the stock market has outperformed real estate, suddenly today some investors are willing to bet that real estate will outperform stocks forever, just because their house has appreciated more than their US investment portfolio over the last 5 years.

There is great danger in extrapolating short term trends.  Since the US twin deficits have grown recently, many think that the entire US economy is destined to go bankrupt.  This is like saying that since the traffic jam hasn't moved in the last 5 minutes, we will never get home.

Finally, extrapolation also leads to poor decisions.  If an investment goes down by 10% one month, there is danger in extrapolating that within a year, it will be worthless.  Similarly, if performance is good, a market segment that doubles rapidly like the .com stocks of the late 1990's can lead people to chase returns that simply cannot continue. 

Mental Accounting

While financial accounting helps us understand how different aspects of a company or our portfolio are performing, mental accounting can often result in strange decisions.  Here are a few real life examples:

If you were heading to a hockey game, musical or theatre event, and lost the $100 ticket on the way there, most people surveyed would not pay another $100 to purchase a replacement ticket.  However, if they lost $100 cash on the way to picking up their reserved ticket at the box office, almost all people would take another $100 from the ATM and purchase the ticket.  But in either case, the net effect is a $100 loss, but in one case the extra $100 comes out of general funds, as opposed to having a $200 cost associated directly with a ticket that is only worth $100.  How you frame an investment decision is very important.

Would you walk three blocks to a discount store to save $10 on a $20 book?  Many people would, especially when it is advertised at 50% off.  Would you go the same 3 blocks to save $10 on a $450 television?  Most people wouldn't.  But it is the same $10 saving, but the sign saying 2% off the TV doesn't really attract the crowds.  Mental accounting can produce strange effects.

People will complain about gas prices, and drive 5 km to buy gas that is 5 cents cheaper for a litre (see www.torontogasprices.com).  They then pay $1.50 for a litre of water at the gas bar, they could have had for free at home.  Considering that in a typical vehicle, it costs around 10 cents in gas to drive 1 km, the extra 10km, plus the water totals $2.50, and completely negates the price saving on 50 litres of gas!

With mental accounting, it is important to examine the overall intention.  While it may be frustrating that one or two funds or sectors in a portfolio are not performing up to expectations, if the overall return is appropriate, then the underperformers actually mean that you are diversified.  

Overconfidence

People tend to overestimate their own abilities and knowledge.  In some respects this is merely curious.  Ask 100 people if they are good or bad drivers, and virtually all will say they are good drivers, but in fact only 1/2 can be above average.  

When it comes to financial matters, some investors believe that they can read the odd newspaper article, and then pick stocks as well as or better than investment professionals who have years of training and experience and perform daily stock analysis for a living.  This overconfidence is compounded by the fact that 1/2 of all fund managers are below average in their category (by definition).  But for an individual investor to therefore assert that they can outperform the average professional fund manager, is likely overconfidence. 

Loss aversion

Investors are very sensitive to losses, more so than they appreciate gains. So they try to avoid losses at great costs.  Imagine a coin flip game where you could win $200 if heads comes up, or lose $100 if tails comes up. Many people would choose not to play, as the risk of the loss is more painful than the benefit of the gain.  However, if you played this game repeatedly, you would clearly come out ahead. The analogy in this example to the stock market is clear.

Strangely, people are Risk Adverse in seeking gains, and Risk Seeking in avoiding loss. As a result, they may be reluctant to sell a bad investment, even though they would never buy more of it. 

Conversely, if investors review their investments too often, they will sell and never invest again, missing out on the long term gains.  This danger of viewing and changing investments too often, is known as Myopic Loss Aversion and is well documented.

Anchoring

Investors often feel the fair price of an investment is exactly what they purchased it for.  As a result, they may too quickly sell out of investments that are performing well and hold onto some real duds, planning to sell "once it gets back to where I got in".  In their minds, they have anchored their view of the investment's worth to the price they paid. However, the current value of an investment is what the current market is willing to pay for it. The best test of whether to hold on to an investment is always to ask, would I buy it now at the current price?

Reference Dependence

"That stock was $100 last year, now it's trading at $10 - so it's got to be cheap." Similar to Anchoring, this is known as reference dependence, and it's the tendency to focus on some arbitrary point of reference.  Interestingly,  clients who owned a particular fund (say Templeton Growth) for 15 years love the fund, people who owned it for 5 years hate it, or 2 years, again love it.  It is the same fund, only the investment time frame and reference is different.

Round Numbers

The special nature of round numbers is an interesting curiosity.  For some reason, people are much more likely to set a stop loss order on a stock at $20 or $25, than at $22.75.  But there is no special reason why a stock would be more likely to be "worth" any particular round number.

Representativeness

Investors and people in general tend to notice patterns where none actually exists. "Every month, my automatic purchase happens at the best/worst price."   These patterns are no more relevant than seeing heads instead of tails 5 times in a row in a game of chance.  The outcome of the next coin toss is still 50/50.

Saliency

We will sometimes hear:  "I don't want foreign investments, they aren't performing well right now"  Although US and foreign investments are the best performing asset classes historically, the investor believes that the recent strong performance by the Canadian market (which is only 3% of world markets) will continue into the future, and precludes the well documented benefits of diversification.

Similarly, people will often focus on the very remote probability of a disastrous event (e.g. child abduction by a "stranger") when statistically there are many more preventable risks that can easily be avoided (e.g. reducing the risk of head injury by having a child wear a helmet while biking). 

Hindsight Bias

Hindsight bias refers to our tendency to remember positive outcomes and repress negative outcomes.  Why didn't we just put everything into bonds when rates were 8%, that part of the portfolio did so well?  This is hindsight bias, and stems from a failure to remember the reasons that a decision was made (e.g. concerns about inflation, other better performing asset classes etc.)  As a result, and knowing that no decision will ever be 100% perfect, diversification plays a key role in any investment program, so that the number of missed opportunities will be in line with the number of successes. 

With hindsight, saying that everyone knew that tech stocks were overvalued is not true.  At any point, exactly half of investors think an investment will appreciate in value, and half think it will decline - that is what sets the current price.  However, if 1/2 of investors haven't noticed that "investor psychology" influences their decision making process, there exists an opportunity for others.

Illusion of Truth

Two for the price of one is a simple concept.  Many investors attribute an upcoming stock split to be a "good time to invest".  Simple concepts can be easier to accept than more complicated theories.  However, finance theory says that stock splits should be non-events, having twice as many shares outstanding means that the shares should be worth exactly half as much as the company has not changed.  However if enough market participants buy a stock once it has become 1/2 price due to a stock split, in fact investor psychology has triumphed over rational analysis.

Summary

So while the efficient market hypothesis says that all markets trade at rational prices since all information is known to all market participants at all times, investor psychology suggests that by knowing some of the pitfalls that real people encounter, we can all be better investors.  When helping you with your investment decisions, Allan and I take this research into account. It is just one of the many tools we have gathered during our many years of experience advising you on the correct make up of your investment portfolio.

More on Investor Psychology

Fund Fees Dropping

An April study by Investor Economics of Toronto has concluded that Management Expense Ratios (MERs) on Canadian investment funds have dropped between December 2003 and December 2004.  In 29 of 33 categories, the fees paid by investors for management of their funds fell.  Only in the small categories of mortgage, small cap, resource and high yield, did MERs rise.

Management fees are set in the fund's prospectus, and reflect the fees payable to the fund company for managing the fund, and for advisor compensation (the trailer fee).  The management expense ratio includes the fixed management fee, and the variable costs of audit, reporting and other expenses which decline as the fund grows.  As many funds have merged in the past few years, it is logical that investors are beginning to benefit from the economies of scale.

Following Fidelity's lead earlier this year, CI has now also announced broad reductions in their management fees, and will be capping MERs on many of its largest funds.  We applaud CI's initiative, and look forward to similar announcements from other fund companies in the future.

Investment Portfolio Quarterly, Spring 2005 Edition

The spring edition of ScotiaMcLeod's Investment Portfolio Quarterly is now available.  The publication outlines projections for economic growth, oil prices and which stocks may do well under a variety of scenarios.  There is also a review of Individual Pension plans which are now available through ScotiaMcLeod.  

2.4% Daily Interest Available in Altamira Cash Performer

We are pleased to announce that ScotiaMcLeod accounts can hold the new Altamira Cash Performer fund, which is currently yielding 2.4% daily interest.  Simply call us to ensure that your daily interest investments (cash balances, or money market funds) are getting the best rate available.  The deposits are CDIC insured through National Bank.  With a low $1,000 minimum investment, and no purchase, transfer fees or redemption fees (after 90 days), it is a great place for short term money.

Scotiabank Named Top Performing Bank In Global Survey

A global survey of bank shares has recently crowned Bank of Nova Scotia the top performer in the world over the last five years.  Scotiabank's stock price growth has reflected the steady profit growth and continued strength from international operations.  In a related announcement, ScotiaCapital was named Investment Bank of the Year for the second year running.

Mutual Fund Reporter Recommended Website of the Month

While parts of the Financial Pipeline site haven't been updated in a while, the bibliography page on investor psychology is the most extensive one we've seen.

 

 



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