Advocates of behavioral finance – sometimes known as behavioral economics or investor behavior – have spent nearly 50 years exploring the investment decisions people make and why they make them. Simply put, behavior finance is a subset of psychology focusing wholly on how we behave when money is at stake. There are three emotional biases that we want to touch on this week.
Dear Clients & Friends,
Over the last several months, we at MORWM have shared our strong belief in two basic concepts: 1) The economy is experiencing a cyclical slowdown; 2) The world is not facing a 2008-type meltdown. Like the seasons of the year and many aspects of natural life, the economy also goes through cycles. There does not appear to be, however, a train barreling down crowded tracks with no one watching- which was the case with the subprime mortgage crisis. A wide discrepancy between the depths of fear many private investors have about a possible permanent market collapse, and the reality of a periodic slowdown, brings long term investors a unique opportunity.
“Be fearful when others are greedy, be greedy when others are fearful.” – Warren Buffet
Before we touch on the topic of this weekend’s reading “To act or not to act,” I’d like to share a statistic not often discussed in main stream news. Vickers Research Corporation publishes an index which tracks what corporate insiders do with their own company’s stock. It is assumed that no one has a better pulse on a particular company than its own insiders. As such, one can deduce insider sentiment by following when insiders of a particular company are buying or selling their own stock. This can also be very telling when you see, on average, the Vickers index widely contradicts investor sentiment- such as right now!
Based on the metrics used by Vickers Stock Research, corporate insiders currently are sending a strong, unambiguous “buy” signal. Originally, this index is considered bullish when there is little selling, and bearish when there is a lot of selling. This is because insiders are heavily compensated with stock options and stock grants of their own company, so many insiders sell periodically no matter the current economic climate so that their personal net worth is not too overwhelmingly compromised of a single stock. At this juncture, the Vickers’ Total One-Week Sell/Buy Ratio currently stands at 0.90, meaning that insiders are actually reporting more buys than sells. This is significant given that insiders typically sell more often than they buy due to the aforementioned nature of their compensation structure. In addition, the less volatile Vickers’ Total Eight-Week Sell/Buy Ratio stands at 1.10, its most-bullish reading since October 2011.
Insiders are generally long-term investors and will often exploit broad market retreats to add to their positions. This has clearly been the case in the current market pullback, as indicated by the Total One-Week Sell/Buy Ratio, which has now posted solidly bullish readings for 10 consecutive weeks. Just as compelling is the fact that insiders are now in direct contradiction with private investors, and we know the private investors often do the wrong thing at the wrong time. Private investors are notorious for buying high and selling low, letting fear sit in the driver’s seat. This psychological “action” is the topic of this weekend’s reading.
Advocates of behavioral finance – sometimes known as behavioral economics or investor behavior – have spent nearly 50 years exploring the investment decisions people make and why they make them. Simply put, behavior finance is a subset of psychology focusing wholly on how we behave when money is at stake. There are three emotional biases that we want to touch on this week.
Projection Bias
Herding Bias
Action Bias
Projection Bias is the tendency for humans to assume that whatever is happening at any given moment is likely to persist, and the accompanying worry that the current climate will intensify. During periods of strong markets, risk averse investors may anticipate even greater future strength. Expectedly, the same investors during periods of turmoil will likely fear worsening losses. This particular subset of projection bias is known as the “Recency Effect”, or “Representativeness” which over-emphasizes current experience as an indicator of the future. This is expressly why virtually every investment analysis that incorporates past performance reminds the reader that past performance is not indicative of future results. Projection bias is also among the reasons why private investors often get into good markets too late, and often pull out of bad markets unnecessarily.
Herding Bias is much better known- it is the concept that many people take great comfort in following the herd. Like other social animals, humans instinctively follow the behaviors and opinions of the majority to feel safer and to avoid conflict. In fact, studies show that the brain actually secretes a chemical to the prefrontal cortex to create pain in the brain if you are forced to go against the crowd.1In the investment world, we know this as the “bandwagon effect”; why individuals are driven to follow short term market trends which tend to provide short term fulfillment at the expense of long term results. The bandwagon effect also tends to create massive displacements in the investment markets as the herd throws away the baby with the bathwater. Disciplined, value oriented investors like Warren Buffet are able to profit from these displacements by purchasing cheap investments during bear markets, then watching those investments endow lucratively over many years.
Action Bias is probably the least discussed and the most obvious. If we feel like things aren’t going our way, we take action, any action. “Whether it’s herd behavior or something else causing anxiety, for most people, taking action feels good. Action is the antidote for anxiety.” 2 Unfortunately, sometimes the right action to take is no action at all. In the mindset of a prudent, disciplined investor, the “action” is the elbow grease put forth in examining the situation, analyzing one’s portfolio, using metrics/valuations/technicals to determine what, if any, action is needed. If action is then taken, it’s more of a reaction to one’s analysis, rather than an action in itself. Why such a convoluted explanation? If a transaction, trade, or movement within the portfolio is the only thing seen as action, investors are more compelled to do something for the sake of doing something which is usually not in the best interest of the portfolio. On the other hand, if you consider the analysis to be the action, then making a change for the sake of taking action is no longer a bias.
Combining these three biases in turbulent times can lead investors to make dangerous decisions. First we project, and assume that anything bad will inevitably get worse. Then we herd because everyone else is scared, and the news media who profits from our fear encourages this herding. Then we feel that if we don’t do something, anything, that we are ignoring some hidden problem. The result- we sell low after having bought high.
In my career, among the most interesting things I’ve experienced is the human side of investing, the human side of financial and mortality planning, and the interesting reactions and decisions made by fellow human beings during times of concern and times of exuberance. If we believe that the markets are slowing but not broken, the best course of action will be to maintain discipline, and take advantage of market displacements. Our pledge to our clients and friends is to do exactly that and we hope that everyone in the MORWM family knows that we are taking action every single day, even though more often than not, such action does not result in a transaction.
To that end, we wish everyone a wonderful weekend, and let us hope that this week’s upward momentum continues.
Matt
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC
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The majority of this content was written and distributed MOR Wealth Management, all rights reserved. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency.
Footnotes: 1- Virginia B. Morris, AGT Behavioral Finance, Lightbulb Press, 2008 2- Kol Birke, Masters in Applied Positive Psychology, UPenn, Senior VP, Technology Strategy and Financial Behavior Specialist, Commonwealth Financial Network, CFP