Psychology Of Investing – by Jonathan Swanburg

This week we hosted a seminar at our office covering the psychology of investing, with tie-ins to the upcoming election and the current state of the markets. 

A full copy of the slide deck can be found here.

Rather than recapping the entire presentation, for this note I’m simply going to highlight a thought experiment from the initial slide.

Based on past performance, which of these investments would you like to own going forward?

The orange line was once worth $17 but now is worth only $8 and seems to be trending lower.  The green line was doing okay until it fell off a cliff.  The yellow line doesn’t lose money, but it doesn’t go up much either. 

Most people would prefer the pink line.  It is consistent and goes up like the green line without all the volatility. 

But in the real world, there are no free rides.  In the real world, here is what happened next:

The orange line represented the share price of Pfizer, the green line was the US Stock Market, the yellow line was US Treasury Bills, and the pink line was Fairfield Sentry – an investment fund that operated as a feeder for Bernie Madoff. 

Why is this important?

Because humans aren’t wired to be good investors.  We suffer from loss aversion bias where our desire to avoid loss is twice as powerful as our desire for gain.  We suffer from recency bias where we believe what happened in the recent past is likely to continue.  We suffer from confirmation bias, where we give more weight to the ideas that support our beliefs and discount those that contradict.

Humans are afflicted by dozens -if not hundreds- of these mental quirks that make us bad investors and the best way to improve long-term returns is not stock research or frequent trading.  The secret is identifying all the ways we are predisposed to self-sabotage so we can put ourselves in positions to not do those things.

Know thyself.

If the thought of seeing your portfolio go down 30% makes you sick, don’t own a portfolio that is going to go down 30%.  Alternatively, come up with mental accounting tricks to make the drawdowns more palatable.  For example, “I have 10 years of safe money to cover my living expenses in a spending account and therefore don’t have to look at the stocks in my long-term account” is often a more viable mental framework than having all assets in a single account with a 60 / 40 allocation.

The math between the two scenarios may be no different, but the cognitive biases running our lizard brains never worry about the math. 

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No kid pics in this note but someone at the seminar remembered that it had been awhile since Austin, Crystal and I last took a picture together.

And since this is my last note until November, Happy Halloween!