Why Investors Do What They Do: Diversification

In his classic book "Portfolio Selection" co-Nobel prize winner Harry Markowitz describes his topic as something other than securities selection. He suggests that a "good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

Diversification often involves numerous human emotions and misuse of it is often the result of some of the topics we have already discussed (loss aversion, narrow framing, anchoring and mental accounting with herding, regret, the impact of the media and optimism all as yet discussed). But diversification is a way to avoid being wrong. It is a way to avoid regret. And when you are wrong, you tend to be really wrong.

These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In order to avoid too many economically obscure references to diversity we will boil the discussion down to two theories: the expected utility theory and the case-based decision theory. The first theory suggests that if the investor is indifferent to an investment, in other words they are so similar that she/he doesn't care either way, that this actually becomes a form of risk aversion and hardly ever produces good long-term satisfaction with those choices.

In the instance of Case-based decision theory, Mohammed Abdellaoui offers the following from his book "Uncertainty and Risk": "it is assumed the decision-maker can only learn from experience, by evaluating as act based on its past performance and on the performance of acts similar to it." This leads to chance decisions.

But what is often overlooked is that not only do you decrease your chances of being wrong, you by default increase your chances of being right. Diversification will spread the risk and as a result of that, may allow you to miss the next hot stock or mutual fund. Because it is impossible to pick the future based on the past - recall the reminder that past performance might not play a role in future results - diversification makes the chances of getting some of the hot property but not all of it.

Consider this simple question: if Rome is located between 41°54' North Latitude, which American city lies at a similar latitude - Boston, Atlanta or Miami? Most folks when asked this question go with either Miami or Atlanta and do so with more than reasonable assurance that they are correct. But Boston, with 42° 21' 29" N is actually the closest by comparison.

Unfortunately, as Robert Hagin author of "Investment Management" points out that people when people make investment mistakes - something that can afflict both professionals and non-professionals, they fail the old adage of "a problem is not what up don't know; it is what you do know."

The most difficult part of investing is removing guesswork and the wishful thinking you may have for the act. Not easy by any means. But much easier if you don't overthink the act of spreading your risk.

Next up: Herding

Why Investors Do What They Do: Anchoring

So far, we have discussed loss aversion and narrow framing, trouble spots in any investors view of what they are trying to do. They may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring.

Unfortunately, anchoring is a bias. It is often included among other similar cognitive biases such as memory bias (which effects how we recall a situation after the fact) and confirmation bias (depends largely of what you already know and uses this information to skew your perception of what really is). Each alters what we see with something we already know and this drives businesses, who want to anticipate what you will do and more importantly, what you will buy and confounds psychologists, who have twisted the lab questions done on test subjects in every conceivable way only to find out that we have numerous cognitive influences mucking up the works.

But anchoring is particularly dangerous when it comes to investor reaction. An anchor is basically an expectation. We are not the kind of shoppers who go into a store, find a good and before we flip the price tag, try and determine what we will pay for it. But it is a good experiment that you can conduct on yourself. Time after time, you will find your expectations of the cost of the good, be it a television or a dress will be altered by what you perceive.

You will try and narrow down your choices to one that seems to be what you think something is worth. But that narrowing of thought, trying to get closer to the price tag (and feeling very smug if your bias towards the cost is exactly what the cost is) will not work across a broad spectrum of goods. In lab tests, subjects merely get "a good" and know little about what it is. But as soon as the item is revealed, adjustments are automatically made.

We generally have no real anchor when we begin investing except for the money we begin the process with. This becomes the anchor if you have nothing in the account. But in a upwardly moving market, an investor can quickly get swept up in a constantly readjusting balance. Once money is made, a new anchor is created in your view of that portfolio.

Investing however is never quite that simple. While we all enjoy growth, we tend to lose focus on the fickleness of the markets and the underlying worth of whatever it is we are buying. If a stock or a mutual fund has had a great run of it, even topping the top ten lists, investors will not see this as the top but the new value on which to anchor their expectations.

Consider what cognitive abilities (or biases) you may have used or borrowed from someone else. You watch the business news channels hoping for a tidbit of relevant information about which security you would like to buy. You peruse the web looking for confirmation of what you would like to believe is true. But what you are really doing is looking for an anchor using someone else's anchor to support your decision.

If analysts make forecasts or predictions based on past performance and then offer the disclaimer that future results are not guaranteed. They have used past results to anchor their bias as to whether things look rosy or the future is bleak for the stock.

Anchoring is tougher on a retirement account largely due to the set and go approach that most investors use in these types of accounts. Unless severe market downturns capture our attention in the news, we tend to leave these accounts to their own devices, channeling a portion of our earnings into them each week.

But when we do look at those quarterly statements, and many of us have for the first time in a while, we have an idea of where we should be. And it will be much higher than is probably reported. That's because we aren't so good at making predictions or estimates.

Look at it this way. Suppose you invested a thousand dollars in an IRA account and added $100 a week to that account. Over the course of 25 years you would have put $114,429 (adjusted for inflation at 3% on the real value of $131,000 actually contributed) in the account. If the money grew over that period at a modest 5%, which for that stretch of time is below average even with last year calculated into the mix, you would have added almost $135,000 in earnings (also adjusted for inflation).

Now suppose your portfolio balance of $249,402 dropped 30% or $74,802. Wouldn't you still be in the black? With an inflation adjusted contribution of $114k, haven't you protected your money and even grew it by $40k. Because you constantly shift your anchor or readjust your estimates higher, your expectations follow.

This is due in large part to a small target. Your balance may have grown substantially since you began investing but what occurred caused you to miss the target. I am not a shooter but I know that when a person does aim and fire, they are often narrowly focused on the target when in fact we should be making broad sight adjustments.

Next up: Mental Accounting

Why Investors Do What They Do

A recent report done by Dalbar, inc. of Boston suggests that investors often do things that hurt what they are attempting to do in numerous ways. Using information aggregated from the Investment Company Institute (ICI.org, a company that tracks and support the mutual fund industry), The Standard and Poors Company (the standard bearer of indexes) and Barclays (which publishes an index of bonds), the company has found that there are numerous influences, both external and internal, that have an effect on how well a portfolio of mutual funds (or stocks for that matter) perform over the short-term and long-term.

They identify nine areas where investors thought they were right, when they were in fact, ignoring signals that the approach they were taking may have led to, even exacerbated losses rather than gains. The report cites these facts from the study to support these claims:

* For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period.
* Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.
* Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index. This disparity is largely due to the underperformance of managed bond funds caused by mortgage-backed securities.
* With an annual loss of 30% last year, asset allocation fund investors fared better than equity fund investors.

The first of these nine areas, which we will examine over the next nine posts, deals with loss aversion. Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made.

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that "since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones." They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker.

How you frame the argument (in an investor's mind), even if it is the same problem, directly affects how the investor reacts. Frame it negatively, and the reaction often leads to risk taking; frame it positively and the investor will chose a risk averse solution.

The battle between what "would happen" if a decision is reached is often overshadowed by the repeated decision making based on what has already occurred. Economists refer to this as a continuous process suggesting that an investor might become overconfident and that generates irrationality.

Martin J. Pring once said, "For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming." According to a Stanford University Business School paper published in July of 2006, "the principle of loss aversion is not derived from any theory of behavior or more basic psychological principles, but is an ad hoc principle introduced to account for a range of phenomena involving tradeoffs between losses and gains." In other words, most investors seek the status quo.

And to change the status quo, investors need a motive. What happens if those motives are fuzzy or ill-defined? The paper, written by David Gal cited an experiment done by Kivetz and Simonson which "offered diners a reward program in which they could receive a free meal at a dining hall after having paid for a certain number of meals. In a between subject design, they found that sushi lovers would actually prefer a reward program which required the purchase of 10 sandwiches and 10 sushi platters to a program which required only the purchase of the 10 sandwiches. Although the former option was dominated by the latter, sushi lovers perceived a relative advantage in that they would likely have eaten the sushi anyway. Based on this relative advantage, sushi lovers inferred that they were getting a "bargain" in an absolute sense."

When information is fuzzy though, it is difficult to determine what the status quo actually is. If you were offered a 50% chance of losing $100 or a 50% chance of winning a $100, the trade-off might seem relatively straightforward. The better bet is to not take the bet at all. What is needed although is a clear preference of what the status quo is.

Loss Aversion does exist but it is difficult to define and hard to expect. Studies have shown that historical data (past performance indicators) often lead us to make these decisions and yet, that same historical data may have little to do with what we may gain, or lose.

Next up: Narrow Framing of Investment Decisions