“To Become a Better Investor it is Key to Understand Our Very Real and Very Human Biases”

Lew Sanders, the founder and CIO of Sanders Capital Management gave a speech at the Columbia Business School detailing his work in behavioral finance and investing.  It is a great expose of our innate human biases, which directly interfere with our rationality and ability to make sound investment decisions.

Here are a few of Sander’s key points:

A Preference for Certainty:  

Unsurprisingly, people have a strong preference for certainty.  In investing, this manifests itself in investors having a preference for financial assets where the outcome appears to be certain.  This leads the average household to hold a very high percentage of its net worth in assets they view as having certain outcomes, despite their lower long-term returns (savings accounts, CDs, municipal and Treasury bonds).  Conversely, those assets perceived to have a higher degree of uncertainty (stocks, high yield bonds, etc) are underrepresented in the typical household, despite their history of higher long-term returns. Two example help to illustrate this.

Choice A:  You have a 33% chance of getting $2,500, a 66% chance of getting $2,400, and a 1% chance of getting nothing.  

Choice B:  You have a 100% chance of getting $2,400.

The expected value of Choice A is $2,409, $9 higher than the $2,400 expected value of Choice B.  Despite this, people choose the certainty of Choice B 82% of the time. We feel the small expected value gain was simply not enough compensation for the wide range of outcomes in Choice A.  The preference for certainty at work.

Gambling Bias:

When dealing with low probability scenarios, people tend to irrationally gamble.

Choice A:  You have a 1% chance of getting $6,000 and a 99% chance of getting $0.  

Choice B:  You have a 2% chance of getting $3,000 and a 98% chance of getting $0.

Despite both choices having the same expected value ($60), people chose Choice A 70% of the time.  Why? When people have a very small chance of winning a large amount, they will tend to choose the lowest odds with the highest payout.  The popularity of lotteries, with their extremely poor expected value, is a classic example.

Loss Aversion Bias:

People react irrationally when dealing with investment losses.

Example 1:

Choice A:  You have an 80% chance of getting $4,000, and a 20% chance of getting $0, with an expected value of $3,200.

Choice B:  You have a 100% chance of getting $3,000 ($3,000 expected value).

Despite the fairly wide expected value advantage of Choice A ($200), people choose Choice B 80% of the time.  

This shows certainty bias, which we have already discussed.  What is interesting, however, is what happens when we use the same numbers from Example 1, but make the numbers negative:

Example 2:

Choice A:  You have an 80% chance of losing $4,000, and a 20% chance of losing $0, with an expected value of -$3,200.

Choice B:  You have a 100% chance of losing $3,000 (expected value -$3,000).

In this case, despite Choice A having a wide expected value disadvantage (-$200), people now choose Choice A an overwhelming 92% of the time.  Investors gamble to avoid a certain loss.

Conclusion

We have all heard the old quip: “We have met the enemy, and he is us.”  This is never more true that in the world of personal finances and investment.  From certainty bias, to a bias to gamble, to loss aversion, investors need to build in safeguards.It is critical to be aware of how our innate personal psychology works to our disadvantage, and work with an advisor who can help you combat these tendencies which tend to inhibit long-term investment success for so many.  

"Financial Planning Calls For Prudence, Not Self Deception"

An article in the Wall Street Journal (“The Market Isn’t Going to Save You From Saving Too Little”) raises an interesting point about savings rates, investment returns and financial planning projections.

 The article details how public pension funds are projecting a continuation of robust investment returns, rather than increased saving, to get them to their funding goals.  The problem is, the next decade is likely to produce lower investment returns, maybe meaningfully lower, than the last decade. This is due to the current starting point of today’s asset valuations.  Long-term equity valuations are very high (which implies lower 10 year returns), and bond yields are very low, well below their long term average yield.

There is an element of self deception at work.  It is far simpler for the pension fund to assume high investment returns, as that removes the need for them to take any near-term pain through increased savings.  As the article points out: “These pension funds are living a convenient dream. Every cut in their [investment return] forecasts results in billions of dollars having to be plowed into the funds to make up for the shortfall, meaning higher taxes and worker contributions.”  Like so much in life, it comes down to character. These pension fund executives and state politicians likely know these investment return assumptions are too high, but the implications of coming clean and being prudent in raising funding (or cutting benefits) would be detrimental to their careers.  And so they take the easy and deceitful path. If they are wrong, the implications may be massive, but they are far enough in the future, that the offending parties will likely be retired.

The lessons for the individual or family is clear.  Do not deceive yourself. Be prudent. Whether we are looking to fund a child’s college education in 10 years, or one’s retirement in 30, the prudent course of action in today’s investment landscape is to lower investment return assumptions and increase savings.  Yes, it involves delayed gratification for a benefit on the distant horizon-but that is what successful investing and, really, life is all about.

The key questions to ask yourself in financial planning is: “What if I’m wrong?”  and “If I am wrong, what is the impact of that?” For the pension funds banking on elevated investment returns, should they be wrong, and returns turn out to be lower over the next decade, they will be on the verge of insolvency and unable to honor the obligations they’ve promised without an enormous tax increase or benefit reduction-both dire outcomes.   For the prudent saver/investor, if they are wrong, and returns stay elevated, then their projections were too pessimistic, and they ended with an overfunded goal-not a bad situation. The prudent investor is in a win/win scenario, versus the pension funds win/lose everything outcome.

Let’s run this scenario out with a real example.  Let’s say John and Jane want to buy a house in ten years, and are looking to have a down payment of $350,000, starting with $50,000 in savings today.  If they took the pension fund approach, then a conventional 60% stocks /40% bond portfolio would return the historic 7.2%, which would call for roughly $16,700 per year in savings.  After 10 years, the couple would have $350,000 ($217,000 in savings and $133,000 in investment returns). If it turns out they were right, and their optimistic scenario was realized, they can fund their down payment.  If they were wrong, however, and investment returns were, say 3.5%,they would have only $273,000, only 78% toward their goal, and perhaps unable to buy the home of their dreams.

Now let’s say the couple takes the prudent approach, lowering their investment return to 3.5%.  This would entail the near term sacrifice of saving an additional $6,300 per year, or a total of $23,000 per year.  After 10 years, the couple would have $350,000 ($280,000 in savings and $70,000 in investment returns). What if they were wrong and their forecasts were too conservative, and returns were the historic average of 7.2%?  Well, they would have $444,000 at the end, with their goal 127% funded. They could use that extra funding to buy a bigger house, put down a bigger down payment, or put it towards a child’s education fund.

Dolan Partners can help you work through these financial planning scenarios to reduce financial self deception, and more prudently structure your financial life .  Nearly 10 years into a bull market, and at a time of historically low volatility and elevated asset prices, now is the perfect time to get together and craft a battle plan for the next decade, no matter what it brings.