Active investment management’s weekly magazine for fee-based advisors

When investors ask, ‘What’s your best idea?’

by Dec 14, 2022UpClose

When investors ask, ‘What’s your best idea?’

by Dec 14, 2022UpClose

During market declines, investors—and advisors—need to watch out for cognitive biases. Rules-based strategies help remove emotional decision-making from investors’ portfolios so they can “stay in the game.”

Like many asset-management practitioners, I have acquired a list of frequently asked questions from investors over the years.

At the top of the list is, “What stock should I buy today?” Unless you’re a hedge fund manager with a highly concentrated portfolio and different amounts of conviction for each stock in the portfolio, the answer usually involves a lot more questions: What are your return and risk objectives? What are your constraints?

The second question on the list comes up less frequently—and only during bear markets. But when it does pop up, it is the question: “How low can this go?”

The question is born from a combination of emotion-encompassing macroeconomics and personal portfolio concern. It is usually followed by statements such as “Every day I lose money” and “I don’t want to open my statements anymore because I don’t want to know.” Much of this year has felt like death by a thousand cuts.

The news is no help. With sensational headlines like “Dow drops 500!,” it’s no wonder investors’ emotions are stretched thin. (While we’re on the subject, the news should really start using percentages or some other measure that is relative through time. In 1921, if the Dow fell 500 points it would be a 45% drop. In 2022, it’s about 1.5%.) These headlines are meant to drive investors into a tizzy, stirring up emotions at a time when investors should be thinking slowly and rationally.

The next question on the list is, “What’s your best idea?” Usually, the asker is referring to the best way to construct their investment portfolio. Of course, that also depends on several variables, not the least of which is your objective. But when I get this question during a down market, it’s usually from an investor who is anxious about losing money and looking to act on that anxiety—which can lead to bad decision-making.

Before we get to my answer, let’s take a look at some dangerous behaviors investors can fall prey to during a falling market.

When the market drops, watch out for these investing biases

When the market declines, like it has this year, it’s a good idea for investors to watch out for cognitive and emotional biases that may lead them to make poor investment decisions. Investors can become more prone to these behaviors during turbulent times.

Hindsight bias and anchoring bias are common examples of cognitive biases investors may face.

Investopedia defines hindsight bias as “a psychological phenomenon that allows people to convince themselves after an event that they accurately predicted it before it happened. This can lead people to conclude that they can accurately predict other events.”

For example, some say the 2007–2009 global financial crisis would be easy to predict now.

Reading back through the news of the day, you would see that the subprime issues were contained by the banks, and that financial advisors and mutual fund managers were recommending clients stick to asset allocations and reduce equity exposure about 10% if they felt uneasy about volatility.

On January 28, 2008, The Wall Street Journal published an article by Brian Wesbury, chief economist at First Trust Portfolios, called “The Economy is Fine (Really).” In the article he says, “Models based on recent monetary and tax policy suggest real GDP will grow at a 3% to 3.5% rate in 2008, while the probability of recession this year is 10%.”

Because we know what actually happened in 2008, we can look back to the 2007 Reuters article “Subprime mortgage market woes seen well contained” and realize just how easy predicting the future was. Our ability to look back, see what happened, and explain it is what causes us to have hindsight bias.

Another cognitive bias investors tend to make is anchoring bias, also known as anchoring and adjustment bias. Those with anchoring bias fervently adhere to an initial opinion or adjust it too little when faced with new information.

An example of anchoring bias is waiting for an investment to return to some value like the previous high or the purchase price—or not changing a price target enough to reflect changes to the underlying fundamentals of a business. In a market downturn, it’s easy to latch on to the all-time high or the prior year’s close. Investors need to be steadfast in their risk tolerance, while positioning portfolios for the future based on the information available today.

Investors also need to beware of emotional biases, which can be more difficult to overcome. Emotional biases are the “feelings” about the markets, which are rooted in personal experience rather than data. During market downturns, these concerns tend to be largely driven by fear and can result in irrational behavior, typically at suboptimal moments in the market.

Two common emotional biases in bear markets are loss aversion and regret aversion, which are behaviors that stem essentially from fear.

Loss aversion can manifest in one of two ways. The first is when investors hold investments after the initial analysis no longer justifies doing so. The second is when investors sell appreciated investments quickly to avoid losing those gains. In both cases, there is a suboptimal outcome since investors will hold on to losers and sell the winners.

The other emotional bias is regret aversion. An example of regret aversion is when investors do not take enough risk in their investments to try to prevent making another bad investment. As a result, they take on low-risk investments and may overweight Treasurys or CDs. Inappropriate asset allocation can cause investors to underperform their return requirements and fail to reach their goals.

What’s my best idea for building a portfolio that takes bias out of the equation?

As a practitioner, I encounter these biases regularly. Educating investors and helping them work through them is part of the job. Sometimes it seems to require the skills of an empathetic psychologist and a data-driven soothsayer. Unfortunately, I’m neither.

What I do believe is that quantitative investing methodologies can help remove cognitive and emotional biases like those previously mentioned, allowing testing in historical context and what-if scenarios that could play out in the future. Rules-based investing is a great way to remove emotional decisions from investor portfolios to “stay in the game.”

So, when someone asks, “What’s your best idea?,” my answer this year is to use data to intelligently design portfolios with both historical context and current trends that offer an opportunity to maximize potential. Don’t hold on to preconceived ideas about the future based on past experiences. Let data be the guide. Strike a balance between being cautious and courageous, and focus on the future.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

New this week:

 

William Hubbard, CFA, is a quantitative money-management analyst. He has spent his career focusing on how active management can generate results regardless of market direction. He earned his bachelor’s degree in electrical engineering, with a minor in economics, from Oakland University.

 
Recent Posts:

Advisors make the case for active investment management

Financial advisors favor third-party active investment management for a wide variety of reasons: access to modern analytical strategies, emphasis on risk mitigation, and the ability for client portfolios to be responsive to changing market conditions over full market...

Will ‘bad news’ actually be bad for markets again?

Before the significant week-ending rally last Friday (Jan. 20), much of the financial news commentary had centered on a consistent theme in response to the market’s recent weakness: “Is bad news bad again?” CNN focused heavily on the “impending debt ceiling drama in...