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: Mental Accounting

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification

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