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The Most Dangerous Thing

"All other creatures use their intelligence to survive.  We use ours to destroy ourselves." - Marty Rubin, Author

We worry about stock market bubbles, rising bond yields, politics, debt, trade wars, etc.  The list goes on and on. 

Our focus is often on things we cannot control.  Throughout history, investors have had a similar list of worries.  During the 2000s, it was the internet bubble and the Great Financial Crisis.  The 1990s, it was the Asian currency crisis and the implosion of a massive hedge fund (Long-Term Capital Management).  The 1980s, it was geopolitical tension and runaway inflation.  You get the point. 

While the "worry of the decade" does move markets, it's often our reaction to the constant stream of events that really matters.  The most dangerous thing isn't an extraneous event, politician, or market shock.  The most dangerous thing is you.

In part 1 of the Most Dangerous Thing, we outline the most common emotional biases that can exponentially increase risk of ruin.  The first part of finding a solution is identifying the problem.

Loss Aversion - Investors feel the pain of losses more than the pleasure of gains.  They will go to potentially irrational lengths to avoid losses, including holding losing investments and selling winning ones. 

What's the remedy for Loss Aversion? 

Ask yourself, if I'm starting with fresh cash, would I still buy the investment?"  It's often better to find alternatives with proceeds of the poor investment. 

Overconfidence - Unwarranted faith in one's own reasoning, judgments, and cognitive abilities.  Also known as prediction/certainty overconfidence (i.e. "I knew that was going to happen!").  For example, ~93% of Americans say they were better than average drivers.  A simple commute on a freeway quickly disproves that statistic.

What's the remedy for Overconfidence?

Do more research and come up with a reasonable basis for making the investment decision.  Understand the other side of the trade.  If you feel the need to speculate, establish a "mad money" account for trading. 

Self-Control - People fail to act in pursuit of their long-term goals because of a lack of self-discipline in the short-term.  For example, we know that drinking that extra cocktail at dinner might derail our workout plan the next morning, but we cannot help ourselves.  

What's the remedy for Self-Control?

Automate your saving and investment plan.  Live within your means.  Increase your savings rate with changes in income.  Resist the urge to follow the herd or chase investment fads.  Don't take excessive risk to make up for lack of savings or to "catch up". 

Status Quo - Investors facing an array of choices elect the option that maintains the status quo.  They become paralyzed by options, even if the alternatives are more optimal, and end up doing nothing.  For example, we met a potential client that admitted he was paying a large wirehouse an exorbitant yearly fee, but he didn't want to rock the boat and make a change.  

What's the remedy for Status Quo?

Education is key to overcoming status quo bias.  Understand the impact of poor risk management, excessive fees, underperformance, etc.  Status quo bias is prevalent in bull market environments (people tend to check out during good times). 

Endowment - People value an asset more when they own it.  Just because you own an asset doesn't mean you should continue owning it.  Investors with inherited or concentrated stock positions often exhibit endowment bias. 

For example, when selling real estate, you might subconsciously talk up the property you are selling to fetch a higher asking price (assigning artificial value based upon sentimental reasons like raising your family in the home).  

What's the remedy for Endowment?

Justify every position in the portfolio.  Ask yourself if you received cash vs. inherited stock, how much would you allocate to this security?

Affinity - Tendency to make irrational investment decisions based on how one believes a certain product or service will reflect their values.  For example, investing in companies your friends own or buying a company because it's trendy or popular.

What's the remedy for Affinity? 

Keep the person or center of influence that made the recommendation out of the equation.  Evaluate strictly on the merit of the investment.  Does it fit with your overall strategy? 

Generally speaking, emotional biases never really go away and we all are vulnerable to them.  The key is acknowledging your tendencies and managing the urge to do something based on irrational emotion.  

We mistakenly consume ourselves with things we cannot control.  Financial markets ebb and flow.  In our opinion, investors that identify their emotional blind spots have a greater chance of sticking to their long-term investment plan. 

Source: CFA Institute's "Understanding Behavioral Biases" by Michael Pompian, CFA.

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