In investing, beware the halo effect

People frequently–and incorrectly–attribute wonderful characteristics to something that has succeeded. Just because something has succeeded does not necessarily mean it’s specifc attributes are also excellent.

This issue is succinctly highlighted in the third part of Michael Mauboussin’s Legg Mason article.

The “halo effect is the human proclivity to make specific inferences based on general impressions.” This was first noted over 80 years ago by psychologist Edward Thorndike and was recently described in detail in Phil Rosenzweig’s book, The Halo Effect.

What Thorndike found by studying military officer reviews was that superiors tended to attribute overwhelmingly positive specific attributes to subordinate officers who they had good overall impressions of. In other words, they assigned impossibly high ratings to their intelligence, physique, leadership, etc. based on their high overall opinion.

This tendency can be particularly dangerous in picking investments. Those who attribute outstanding specific characteristics to Apple or Google simply because they have done well in the past and everyone seems to love them may be in for a rude surprise if they invest in these companies at current prices.

The same can be true on the downside as well. People tend to assume that companies whose stock has performed poorly or whose profitability has lagged have universally negative specific characteristics. This is unlikely to always be the case.

The halo effect partly explains why popular stocks tend to under-perform and unpopular stocks tend to out-perform.

People tend to assume that popular stocks have great specific attributes, reflecting popularity more than excellence. When an inevitable blemish appears, the stock tanks because it was priced for perfection

In reverse, people tend to assume that unpopular stocks have universally negative attributes. When it turns out the business isn’t as bad as everyone believed, the stock takes off because it was priced for bankruptcy.

In selecting investments, it’s very important to gain a clear view. Popularity is no way to judge an investment. Look critically at every investment opportunity, no matter how much people love it. And, companies that everyone things are doing poorly may be a great place to invest because good characteristics may have been overlooked.

To avoid the halo effect, look for disconfirming evidence–evidence that conflicts with the popular view. Work hard to understand both the good and bad characteristics of an investment. This will help you rationally assess its prospects, and almost certainly lead to better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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“If only I had…”

The psychology of regret can be very useful in investing.

A recent article by Michael Mauboussin, of Legg Mason, points this out beautifully.

You see, psychologists refer to the tendency to consider what would have happened if you had taken a different action as counterfactual thinking. This way of thinking can work to your benefit, but it can also create traps.

One example of a trap is called inaction inertia. Inaction inertia occurs when you initially fail to take advantage of an investment opportunity, say buying Microsoft in 1996, and subsequently pass over the same opportunity in the future, say buying Microsoft in 1997, because its price has run up from where it was in 1996.

If an investment opportunity is good right now, you should buy regardless of the price you could have gotten if you’d acted earlier. I learned this the hard way with Leucadia in 2002, 2003 and 2004 when I didn’t purchase because the price had gone up, but then finally got it right in 2005.

A benefit of the psychology of regret results from learning about errors of action versus errors of inaction. You see, some regret is good because it encourages future changes in behavior.

Most of us tend to focus on short term regrets related to action. Like, I wish I hadn’t eaten that whole platter of brownies.

But, it can be equally beneficial to also focus on regrets related to inaction. Warren Buffett is famous for bemoaning the investments he didn’t make more than the investment he did make. He knows his greatest investment errors were sins of omission rather than commission.

If you consider both the investments you’ve made as well as the investments you haven’t made, you can learn from your mistakes and become a better investor.

One of the biggest psychological traps investors fall into is due to their psychological immune system. This system exists to help bad situations seem better, but they can lead to big investing mistakes.

“First, we tend to explain away situations in a way that makes us feel better.” Like, someone who gets turned down for a job and tells themselves they didn’t want it anyway. This kind of thinking leads to investing errors that aren’t learned from. Don’t explain away errors dismissively, try to understand what went wrong.

“Next, we seek facts that support our views and disavow or dismiss factors that don’t back us up. This is known as the confirmation bias.” If you read every article that says that Google or Apple is the greatest investment ever, but fail to read the articles critical of those companies, you probably won’t make good investment decisions. Look for evidence that your investment ideas may be flawed.

“We also exhibit hindsight bias. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did.” How many people insist they knew an investment would do well but failed to act. Did they really know it beforehand, or are they just convincing themselves they knew after the fact? Write down your thinking beforehand and you’ll find out what you really thought instead of what you hazily remember you thought.

“Finally, when we make a prediction or take an action that doesn’t work out, we believe we were almost right–the close-call counterfactual.” If I had a dime for every investment I almost made and went up, I’d have a lot more money than I do. Once again, write down what you think beforehand, then you can check to see whether your close-call wasn’t just a rationalization after the fact.

To avoid making mistakes with the psychology of regret, “be aware of how the mind works and the suboptimal behaviors that may ensue.” If an investment is good, make it regardless of the price you could have paid if you’d invested earlier. Be sure to consider your inaction as well as your actions. There may be a lot to learn from what you didn’t do.

Also, “be careful not to kid yourself.” Don’t just explain away situations in a way that makes you feel better. Look for disconfirming as well as confirming evidence. Write down what you think will happen beforehand so you can check whether you are suffering from hindsight bias or the close-call counterfactual.

Understanding the psychology of regret just may make you a significantly better investor. It sure has helped me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

When do we reach our financial decision making peak?

Financial sophistication peaks in our early 50’s. Younger adults and older adults borrow at higher interest rates and pay more fees than middle-aged adults.

These conclusions come from a fascinating paper I read recently.

The authors hypothesized that financial sophistication would depend on a combination of analytic ability and experiential knowledge.

Their research on cognitive aging implied that analytic ability follows a declining concave trajectory after age 20. Our brains function as well as they will in our early 20’s, then degrade from there.

The authors also hypothesized that experiential knowledge follows an increasing concave trajectory due to diminishing returns. The older we get, the more experience we have. The more experience we have, the better decisions we can make. But, each unit of experience does not provide the same benefit as the unit before. Hence the diminishing returns. Our experience helps us make better decisions, but each bit of experience benefits us less and less over time.

When adding together the effect of cognitive decline and experience with diminishing returns, we end up reaching our peak at some point and then our abilities decline over time.

The same thing can be seen in other pursuits. Baseball players peak in their late 20’s. Mathematicians, theoretical physicists and lyric poets peak around age 30. Chess players peak in their mid 30’s. Autocratic rulers peak in their early 40’s. Authors peak around 50.

The authors validated their hypothesis by showing that younger and older financial decision makers pay too much in interest and fees. Sure enough, those in their early 50’s pay the least in interest in fees, seemingly validating the cognitive decline/experience with diminishing returns thesis.

Here’s an interesting question: what age person should you want to work with to help you make financial and investing decisions? Would you want to chose someone in their mid 50’s, whose cognitive abilities are declining and whose experience doesn’t make up for this decline? I don’t think so.

You’d probably want someone on the upswing, someone whose cognitive abilities may be declining, but who has enough experience to make up for that decline. Perhaps you’d want to pick someone who would reach their sweet spot of optimal decision making in the future, who still had the best benefits of aging and experience ahead of them.

Okay, this is a shameless, self-promoting plug. I’m in my late 30’s and will become a better investor over the next 15 years. Doesn’t that sound like the right target, instead of someone with so much experience they’re in decline? If you’re going to work with someone for 30 years to reach your goals, wouldn’t you prefer someone on the upswing instead of the downswing. I sure would.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Social influence plays a big part in outcomes

The success or failure of a venture can be greatly influenced by the early reactions of people.

This statement may seem obvious to you, but a recent academic study recently showed just how important initial reactions can be on success or failure.

I read about the study in Michael Mauboussin’s recent Legg Mason article. Three Columbia University sociology researchers set up a website where people could download music. 20% of the people who went to the website were provided with no information about what others had downloaded. Another 8 groups (10% each) were formed which could see download rankings.

The study showed that top songs tended to finish in the top, and bottom songs tended to finish at the bottom regardless of whether download rankings were available. But, the vast majority of songs in the middle were ranked very differently depending on whether people could see download frequency.

In fact, the study showed that once 1/3 of the participants had downloaded songs, the next 2/3 of people followed their lead. This lead to very different outcomes between the 8 groups who could see download frequency.

In other words, the intrinsic quality of songs was trumped by the cumulative advantage of social influence for the vast majority of songs. Songs downloaded frequently by a group were then downloaded more frequently by others, creating cumulative advantage.

This may seem obvious when you think about Betamax versus VHS digital video tapes, or Apple versus Microsoft Windows, or, more recently, iPod versus any other MP3 player.

The same is undoubtedly true for picking investments. In the short term, people pile into the same investments that everyone else is talking about, regardless of the intrinsic value of the underlying business.

Luckily, the market has the benefit of quarterly and annual earnings reports, which force stock prices to track with underlying value over the fullness of time.

This doesn’t mean that stock prices are always right–quite the opposite.

Don’t judge an investment by what it’s stock does over the short term if you’re a long term investor. Otherwise, you may suffer from the social influence of following the crowd.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

401k investing

Many investors are just plain baffled about how to invest their money. They don’t know where or how to invest to reach a comfortable retirement.

One of the best investment vehicles out there, if it’s available through your employer, is the 401k plan.

Traditional 401k plans allow for pre-tax contributions that grow tax-deferred until retirement (when withdrawals are taxed as ordinary income). Roth 401k plans allow for after-tax contributions that grow tax-deferred and are not taxed on withdrawal (they also provide more flexible withdrawals and better estate planning options).

Many employers match employee contributions. This is like getting a raise in salary, yet less than 66% of all employees eligible participate in such plans.

If a 401k plan is available to you, you should almost certainly be contributing to it.

The earlier you start saving, the sooner you don’t have to work for other people or the bigger your retirement will be. Start saving NOW!

Before you invest, you should learn a few things about the plan available from your employer. You’ll want to know your employer’s policy on matching contributions, the vesting schedule for contributing, and the plan’s maximum contributions.

The hardest part about investing in a 401k–after clearly understanding you should–is picking the right investment(s). Most plans offer anywhere from 25 to 900 choices. Almost all investors are overwhelmed by such choices.

Unlike most advisors, I don’t necessarily believe that investors should go crazy diversifying their money to the 4 corners of the investment world. There are better and worse investing opportunities, and any good investment advisor will know the difference between the two.

Don’t necessarily go for target date funds, either. Their allure seems wonderful because someone else does the thinking for you, but their high fees and necessarily mediocre performance may not meet your personal desires or your investment needs.

Finally, I would advise you not to invest in your company’s stock through such a plan. Your pay check is already dependent on the company, so you probably don’t want your retirement nest-egg to be in the same spot. The folks at Enron, Worldcom and Arthur Anderson found out the hard way what a big mistake that can be.

If you need any help making these decisions, I’d be happy to help. Just give me a call at 719-761-3148.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Your returns depend on the CEOs you invest with

Not surprisingly, what’s happening in a CEO’s life impacts the performance of their company and it’s stock price. A September 5th article in the Wall Street Journal by Mark Maremont highlighted this fact, recently.

Several studies have shown that a death in a CEO’s family negatively impact the company’s stock price. The death of a child resulted in an average loss of 20%. The death of a spouse led to a 15% slip in price. Amusingly enough, the death of a mother-in-law led to a 7% rise in stock price.

Other studies showed that the stocks of companies run by CEOs who buy or build megamansions sharply under-performed the market. This hardly seems surprising to me, but it’s good to see the statistical backing.

Another study showed that narcissistic executives, those who tended to take all the credit for what their companies accomplished, tended to take greater risks that led to bigger swings in company profitability.

Although I’ve never done a statistical study of these issues, I’ve always looked hard at the leaders of the companies I invest in. Not only does this result in better investment results, on average, but it also allows me, and my clients, to sleep better.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bad reasons not to save

Jonathan Clements, who writes for the Wall Street Journal, had a somwhat amusing article on September 9th.

His title was, “Six Bad Reasons Not to Save for Retirement.” I couldn’t agree more.

Bad reason #1: I still have plenty of time.

Say you start saving for retirement as a diligent 25 year old. Your goal is to have $1 million by retirement, which you plan to start at 65 years old. You’d need to save around $846 a month for 40 years.

If you wait until 35, you’d have to save 70% more a month, or $1,441 per month for 30 years. If you wait until you’re 45, you’d have to save 322% more a month, or $2,726 per month for 20 years. If you wait until 55, you’d have to save 803% more a month, or $6,791 per month for 10 years.

It pays to start as early as possible. The longer you wait, the more painful reaching retirement will be.

If you think you’ll earn more money as you age and have more money to save later, you’re right on the first issue but wrong on the second, because I almost guarantee you’re expenses will go up faster than your income as you age.

Start saving as soon as you can, as much as you can, and you’ll reach a bigger retirement with a lot less stress and strain.

Bad reason #2: My house is worth a bundle.

See my previous post on this subject. Counting your home as a retirement asset usually doesn’t work out.

Bad reason #3: My investments are doing great.

They may be doing well, now, but what matters is how they do over the full length of your retirement years.

For those who retired in the late 1990’s with enough money, the sell-off during 2000-2003 slammed them right back into working again. It’s not enough to have a lot of money at the peak.

A retirement plan should be set up with a margin of safety, not merely “enough money to get by as long as everything goes well.”

The best way to get there is to save continuously into your retirement plan (which should be based on reasonable assumptions).

Bad reason #4: I’ll receive a fat inheritance.

Very few people, after inheritance taxes, will receive enough money to retire on, perhaps 1.6% as Clements suggests.

If you are part of that 1.6%, congratulations.

If not, get to saving.

Bad reason #5: I have a pension.

41% of households currently have a defined-benefit pension plan, whereas 62% of workers expect to receive a pension.

If you actually have a pension and are not part of the 21% of “land-of-fantasy” types who expect a magical pension to appear in the future, be sure it will cover your actual expenses in retirement.

Also, keep in mind that, because of recent accounting pronouncements and the expense of defined-benefit plans for companies, many defined pension plans are going the way of the dodo.

If you don’t have a pension or are part of the 21% who are clicking your heels for the future-fantasy-pension, get to saving.

Bad reason #6: I’ll work in retirement.

This is actually not a bad idea.

I love my job and don’t plan to stop working until I’m unable to work, so I can sympathise with this argument.

But, many people don’t want to or can’t work into their 70’s and 80’s.

Planning to work into your 60’s makes sense, but assuming you’ll be capable of working into your 70’s and 80’s is gambling where the odds are against you.

Plan to work if you can and want to, but have enough money saved in case you just plain can’t.

Saving for retirement is like paying for insurance. You may never make a claim or need as much money as you’ve saved, but that doesn’t mean you don’t want to make regular payments so you are safe and secure in your old age.

Save for retirement as soon as you can, as much as you can, and as regularly as you can. You’ll sleep better and have greater peace of mind.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.