Mark LaMonica: Welcome to another episode of investing compass. Before we begin, a quick note that the information contained in this podcast is general in nature, it does not take into consideration your personal situation, circumstances or needs.

We have talked a lot on this podcast about poor investor behaviour. We’ve touched a bit on chasing returns and how despite our own best intentions and seemingly knowing better, investors often buy high and sell low. But first we have to talk about a stretch project that Shani did at work. And Shani was responsible for organising a team photo.

Shani Jayamanne: I was yeah.

LaMonica: And you know I call this, I call this a stretch project obviously jokingly because this is well below Shani’s capabilities, but it turned out to be quite challenging.

Jayamanne: It was – It was like herding cats, there was 15 of us.

LaMonica: Yeah and let’s just say a lot of our team –so Shani outlined what people had to wear in this team photo and we were taking this team photo so that we could put it onto our new website that’s coming out soon, and Shani told everyone what to wear – you just said business casual

Jayamanne: Well I said business casual and I gave them some colours cause we wanted everyone to be kind of coordinated so just neutrals.

LaMonica: Yeah, yeah, it’s not like we were all wearing red or something.

Jayamanne: No, no.

LaMonica: But then the questions started coming. So business casual seemed beyond a lot of people on the team’s capabilities.

Jayamanne: I think some context here is that we have a very mixed team. So we’ve got a product team, marketing, we’ve got a development team – the software developers, and I would say that a lot of the questions did come from one particular team.

LaMonica: Yes, those would be the developers.

Jayamanne: Yes

LaMonica: So Shani outlined – well you gave a lot of specifics.

Jayamanne: Well I started getting individual questions and I was like alright I just need to address this and because in the first stint I didn’t want to be condescending you know or patronising. I didn’t want to send a Google search of what business casual was, to people so.

LaMonica: But ultimately you did it.

Jayamanne: Well I went one step further, I created two Pinterest boards – one for women and one for men. And it had this is what business casual is and the colours.

LaMonica: But then the problem was you told me that people scrolled too far down and they were looking at…

Jayamanne: And it was like auto generated, so it was like hoodies and jeans you know.

LaMonica: Well we did it though.

Jayamanne: We did – everyone looked great. It was great.

LaMonica: Yeah, no we pulled it off and the photographer was very detailed. Like moving around women’s hair and flipping around you know, necklaces, and stuff like that so.

Jayamanne: We’ll see how it turns out.

LaMonica: Yeah exactly - you looked at a couple of them on the camera though. You said they looked okay.

Jayamanne: Yeah, they were great

LaMonica: We’ll see.

Jayamanne: We’ll see.

LaMonica: Alright let’s get back to this.

Jayamanne: Alright let’s get to this episode so, we are going to talk about some of the challenges that investors face just through our human qualities and we will provide some practical tips to prevent this behaviour, but Mark of course insists that we start with some background - so buckle up for some history. 

LaMonica: Okay I’ll ignore that - I think people think that this stuff is interesting.

Jayamanne: I actually find it pretty interesting too Mark.

LaMonica: Thank you. So Ben Graham, who we talk about a lot on here, spends a good part of his writing talking about investor behaviour. He talks about avoiding the crowd, and that as investors our own worse enemies is ourselves. He has a quote that perhaps has not aged well when he said the time to buy straw hats is in the winter. The point of all this is that Ben Graham recognised that it is difficult to avoid doing what everyone else does. But then the 1960s came along, the decade kill off hats but it also apparently killed off the antiquated notion that humans were irrational. 

Jayamanne: And what Mark is talking about here is the emergence of the efficient market hypothesis. And a lot of these ideas were around prior to the 1960s, but that’s when there was a spike in popularity. A lot of this popularity was driven by the P.H.D thesis of Eugene Fama who went on to become a famous Nobel Prize winning economist at the University of Chicago. At a high level the efficient market hypothesis states that share prices reflect all known information and therefore are always priced at their fair value.   

LaMonica: Now a couple conditions have to be met for this to happen. The first thing is that information is instantly available to everyone at no cost. This is needed because for share prices to always reflect all available information, everyone in the market must have that information. The second major condition is that everyone must respond rationally to that information. In other words, they must know how each new piece of information impacts the value of a share. 

Jayamanne: We want to raise awareness on this podcast about different approaches to investing. But we also want this to be about our opinion and Morningstar’s opinion. So I will generously say that we believe that for stretches of time the market may be efficient. And that some parts of the markets that have more investor interest, are more efficient. Big companies in the US for instance.  

LaMonica: But we will also say that we 100% do not believe that markets are efficient. And that is because people aren’t rational. We are driven by emotions and our emotions cause us to do things that don’t align with simply getting the best investment returns possible. 

Jayamanne: And we’ve talked about this before. If I am a portfolio manager that makes millions of dollars of year, that has multiple houses and people that depend on me I might think about my career and not just about what will give my investors the best long-term return. I may think about my next bonus and what will get me another year’s salary. So I will do things that benefit me in the short-term. Owning things that other people own so I’m not an outlier and chasing short-term returns. And no matter what professionals say about being long-term investors the data shows that the vast majority of them are not.  

LaMonica: And I know for a fact that I’m not rational. Every time I think that I am I go back to the GFC. I lived in Boston and I remember so clearly my daily 20 minute walk home and the thoughts that went through my head. I was scared. I heard stories about the financial system crashing – and at the time I was a consultant working with the financial services industry. The guy below me got laid off. And the guy above me got laid off. And when I was thinking about the stock market that was plummeting I was having a hard time staying rational.  

Jayamanne: So the efficient market hypothesis was perhaps a product of its time.  

LaMonica: And if we look back on the 60s we are inundated with this vision of hippies at Woodstock but we need to remember that the 60s were also an age of huge advances in science and technology and in many ways the counter culture was a revolt against the prevailing culture which was conformity and rationality.  

Jayamanne: But things have changed. And once again it is hard to equate this to one person because any intellectual movement builds over time, but we are going to talk a bit about Daniel Kahneman. He also won a Nobel prize in economics. The interesting thing about his Nobel prize is that despite it being in economics he never even took an economics course. He is a professor of psychology and public affairs at Princeton University and he is the father of a field called Behavioural economics. 

LaMonica: And behavioural economics is basically just saying that human decision making is often irrational despite the best intentions by investors. In economic speak it is not profit maximising. And that is what we are going to talk about today. That decision making is irrational and that if we recognise that we can come up with some techniques to help us not make bad decisions. 

Jayamanne: Lets talk about fight or flight. Most people have heard of that being a core human attribute. When we are confronted with something stressful or frightening, we tend to react in one of two ways – we fight or we run. And this is hard wired in our DNA because of fight or flight. Mark – are you more of a fight or a flight guy?

LaMonica: I gotta say if I’m honest I would admit that I would probably run. I’ve run away from bugs, commitment, all sorts of things. But this is what we call an action bias. Which means that when investors are faced with falling volatile markets, we feel – deep in our DNA – that we need to do something.  

Jayamanne: And we feel compelled to act, but action when it comes to investing is often a bad thing. That means that when things are volatile and investments we own are falling we want to do something. We want to sell what we own and buy something that has done better. And that is almost always a bad idea because even if we picked terrible investments, it is likely that our terrible investments have already fallen enough to make them not so terrible investments at their current price. 

LaMonica: And we have to acknowledge that the action bias is reinforced by both the media and by peer pressure. If something happens with the market – either if it goes down a lot or up a lot – you start getting a lot of articles about “what you should do”. And all your friends and family start asking you what you are doing. And to be frank you sound like an idiot if you say that you are doing nothing. 

Jayamanne: The thing you need to guard against is the fact that what you might be doing is just conventional wisdom and it is likely too late. Let’s use a recent example. In the past year the giant oil company Exxon Mobil is up roughly 50%. And we are hearing a lot about how oil is a great investment from the same people that told us 50% ago that it is a terrible investment and that all cars are going to be electric and that nobody will own oil because of the ESG considerations. 

LaMonica: And oil has also been in the news a lot lately because of Russia’s invasion of Ukraine. And the volatility that we’ve seen has caused many investors angst and has caused many investors to do something. And this is natural. Headlines are screaming at you to do something. That 75 years of peace in Europe has ended, NATO summits and sanctions, Nuclear forces being put on alert – certainly doesn’t seem like business as usual.  

Jayamanne: And it isn’t business as usual in a geo-political sense but that doesn’t mean that you need to reactively “do something” with your portfolio. And the something that many investors have done is to invest in oil. And maybe that is the right thing to do and maybe it isn’t. Over the last month Exxon Mobil is up roughly 7.5% which is really good but pretty minor in the big scheme of things if we look at the last year.  

LaMonica: And perhaps oil is going to go through the roof. Or perhaps this will cause more supply to come online. Or perhaps this will actually speed up the end of the oil as people seek alternatives. The point is that we don’t know the investment ramifications of this war. We are a month into it and even though we reflexively want to do something I think we need to acknowledge that if we are long term investors we really don’t know what the impact is going to be. 

Jayamanne: The interesting thing is that action bias impacts you more if you are overconfident or if you have experienced previous negative outcomes where you can infer with hindsight that if you did something you would have had a better outcome. 

LaMonica: And I think this is really interesting because what it is saying is that more experienced investors are more likely to do something stupid than new investors. And we often think the opposite is true but it makes a bit of sense. I can sit there and look at the GFC and think if only I would have sold all my bank shares at the first sign of trouble I would have been a lot better off. And I can say this because the first headlines saying something might be amiss turned out to be the tip of the iceberg. But I only know that because of hindsight. And more often than not the predicted terrible event turns out to be nothing. Shani on the other hand was 14 when the GFC happened so she doesn’t have that view. 

Jayamanne: My favourite example of action bias is actually a sport example. We’ve all seen a penalty kick in soccer. It is exciting. The goalie is standing there all alone and as the other player is approaching the ball the goalie picks a direction and dives. And maybe the goalie has some strategy – he or she has studied video or sees something about how the player is approaching the ball that makes one direction seem more plausible. But lets call it for what it is – it is a guess. Well the best approach actually is to do nothing. To stand right where you are in the centre of the goal and try to save the ball if it comes somewhat close to you. But nobody does that. Standing there seems ridiculous because as humans we want to do something. We want to take action even if that action lowers the chance of achieving our goal – in this case saving the ball.  

LaMonica: And this is the perfect example of action bias. Because if the goalie picks the right direction and makes a save everyone is of course thrilled. The press comes and interviews the goalie which provides an opportunity to talk about how the goalie just knew that the player was going to shoot the ball in that direction. That is hindsight. In reality the goalie just got lucky but that luck and the success that came from it is often attributed to skill. 

Jayamanne: And we will get into some practical tips in a bit but the lesson is that doing nothing is almost always the right choice. And that is hard. Because like the goalie that just stands there in front of a stadium full of people demanding action in the face of the urgent matter of the penalty kick, you will face all sorts of people – the media, your peers, your family – demanding that you do something. 

LaMonica: We are going to go through a couple more of the underlying biases that investor’s have. And we will do this quickly because hopefully you will sense a bit of a theme because they are all related and they are all examples of investors being hardwired to make poor decisions and act irrationally.  

Jayamanne: We believe that we can take the available information and data and make a rational choice. But we are faced with a confirmation bias, recency bias and an overconfidence bias along with a longer list that we won’t go through today. All of these inhibit our ability to think rationally and process information that we receive. 

LaMonica: That’s exactly right. A confirmation bias means that as humans we have the tendency to seek out information that confirms what we already think and discount any information that goes against what we already think. We all accept that it is hard to change other people’s minds but we are less likely to accept that it is also hard to change our own minds.  

Jayamanne: And not only do we seek out this information that agrees with our current thinking we also tend to give greater importance to recent events than historical events. That is of course recency bias. This is why we chase returns. This investment went up last year, or last month or last week so it will just keep going up forever. I should buy it. And this is a terrible investment it went down last year, or last month or last week so I should sell it.  

LaMonica: And the cherry on top is overconfidence bias. That is the bias that we all overestimate our skills. The best example of this is that we all think we are above average drivers. Two thirds of people think they are above average drivers. And of course we know that isn’t true mathematically. But when this comes to investing it means that we are overly confident when it comes to things like market timing. And you hear this all the time when investors say things like – I know when to get out of and into the market. And I need to admit that this is me and my strategy of building up cash. It is all premised on the fact that I will know when to get back into the market. I can say that the market is overvalued because that is a fact when we look at history but that does not mean I will know when to get back in. 

Jayamanne: And we could go on. There is a long list of these biases that impact investors. But the bottom line is that they all just state that we have a lot of trouble making rational decisions. And we especially have a lot of trouble making rational decisions in times of stress and in times when the market is undergoing a shift and is at an inflection point. Which if we are honest might be now. We’ve seen a pretty significant rotation to value after 15 years or so of growth outperforming. Logically there is a case to be made that we are at an inflection point but there are a lot of investors out there that are just saying buy the dip and waiting for Tesla to go up another 200%. 

LaMonica: And we’ve done some research at Morningstar and others have as well into how much our irrationality as investors cost us. At Morningstar we call this the behaviour gap. The way we study this at Morningstar is that we look at the return achieved by a fund and then we look at the return received by an investor. And these are different. The fund return is based on the underlying assets in the fund. The investor return is based on the inflows or outflows of actual investors deciding to buy into a fund or sell out of the fund. Those inflows and outflows have no direct impact on the performance of the fund but the timing of your investments have a huge impact on the return that you get. 

Jayamanne: And the gap is huge. We did this comprehensive study back in 2013 and we looked at 10-year returns and compared the average return of funds and the average returns of investors. We looked at global share funds in the survey and found that the average return over 10 years was 8.77%. Pretty good. And then we looked at the average return that an investor got at it was 5.76%. Not as good. So that difference which is almost 3% a year is a gap that occurred because we make poor decisions as investors. That is the behavioural gap. 

LaMonica: The question of course is how do we prevent this. Well Daniel Kahneman who we referenced earlier wrote a whole book on how humans think and make decisions called “Thinking fast and slow” which outlines the biases we talked about and even more. And the central message in the book is if we want to make better decisions in our personal lives and as a society, we ought to be aware of these biases and seek workarounds. And the same holds true for investing. So lets start with some techniques that are applicable for investing. 

Jayamanne: The first seems pretty simple but it is to write things down. Have a plan that is written down and quantified. Something we’ve spoken about over and over again on this podcast. Set a goal, write down that goal, calculate what it is going to take to achieve that goal. And it doesn’t matter if you change the goal later – when you do just update what you have written down. This goal is your investment objective and it will serve as a guide to all the other decisions that you make. 

LaMonica: And keep writing stuff down. Once you’ve gotten your goal, write down how you are going to achieve it from an investment standpoint. Your goal will tell you how much you need to save and what return you need but now you need your investment policy statement. And I’ve been arguing with a bunch of people at Morningstar how important it is that we help investors do this in our Product Morningstar Investor. And we are finally updating our investment policy statement feature as part of the product and will role it out soon. And I know people think I’m crazy because I want to include just free form fields where you can write down how you are choosing investments to achieve your goals but it is critical to success. Go back and listen to our investment policy statement episode to hear how we are going to achieve our goals.  

Jayamanne: So once you’ve written down your goal and written down your investment strategy and how you will select investments it is time to pick what goes into your portfolio. And guess what – we want you to write down all the reasons that you think this is a good investment and then write down all the reasons you could be wrong. And we can help you here with our bulls and bears section in our research reports. Writing down why you want to pick a particular share or ETF is healthy because it clarifies your thinking and makes sure that you have an actual reason for investing in it. Because you are probably not going to buy it if you just write down – because my uber driver told me to or because it went up last year. 

LaMonica: And writing down all the reasons not to buy the investment is also good because it forces you to think about and research why this may not work. And trust me, for any investment that I’ve ever made or that you will ever make there are a lot of reasons why it may not work. This overcomes overconfidence bias and confirmation bias because you have to think about why you could be wrong.  

Jayamanne: So writing things down is a great first step but we also need to keep working on slowing down any decision making so we can fight our action bias. And writing things down helps. It helps because before you make any decision in your portfolio you need to go back and read your goals and read your investment strategy. Then you read the original reason you bought a particular share or ETF that you want to sell and then research and write down why you want to replace it with a new share or ETF. All of that takes time but that isn’t good enough. We would encourage you to then add a buffer to think things through. Perhaps a couple days or even a week. That even after you’ve gone through this process give yourself some time to consider it and then go back and see if what you’ve written down still makes sense. 

LaMonica: And this is hard because we have all these influences that are telling us that we need to act immediately. Chief among them the share market and ever-changing prices. But realise that the differences in prices in a couple days or a week are going to pale in comparison with that 3% a year that investors are underperforming in the behaviour gap. If you find it hard to have the discipline find a friend or a family member that can be your investing mate. Pitch each other ideas before you make any transaction. I know there is lots of stigma about talking about money but this can be really effective even if they don’t challenge your ideas. The process of explaining it, just like the process of writing it down will help. If I start from zero and invest 10k a year for 30 years and earn a 10% return I get around $1.65m. If I earn a 7% return I have $950k. That is a staggering difference. 

Jayamanne: The other thing that of course facilitates these snap decisions is technology. The fact that you can trade from your phone doesn’t help this situation. We talked about this before in a previous episode but technology has broken down barriers. You used to have to call your broker who could have talked some sense into you if you were doing something stupid. You used to have to pay transaction costs which might inhibit trading. A lot of that has gone away with technology and with cheap transactions. And I’m certainly not arguing that they didn’t bring benefits to investors, but we also need to acknowledge that they facilitate poor investor behaviour and add to the behavioural challenges. 

LaMonica: The last tip is about mindset. Almost every study that is done shows that the default mindset of investors should be to do nothing. Get in the mindset that there needs to be a really convincing reason to make changes in your portfolio. And the most famous study is one done by Fidelity where they discovered that the best returns from people who trade with them came from investors who forgot that they had accounts. Think about that the next time you are about to make a trade. 

Jayamanne: And we could go on and on with studies but we want to make one more really important point. We talked earlier about our mind the gap study. The results that we quoted came from the US. But we also did the study in Australia and the results were very different. In Australia investors actually outperformed the average fund return. It was only by a little bit but that means that investors in Australia got the timing right. And investors in Australia aren’t smarter than other investors but there is a very big structural impediment to doing something stupid – and that is Superannuation. It keeps people long-term focused because you can’t touch the money unless you meet a very narrow set of requirements. Also, many investors have a default set of investments that money goes into, each paycheck, and they just don’t change it. 

LaMonica: Finally we should make the point that all of the behavioural challenges that we’ve talked about in relation to investing are made worse during times of volatility – which we are facing now. The gap increases between investor returns and investment returns as the stress of volatility encourages all of us to act. So please keep that in mind as you invest. Alright so we made it to the end of another one Shani – we’re on a roll.

Jayamanne: We are.

LaMonica: So thank you guys very much for listening, we once again would love any comments or ratings in your podcast app and we would really appreciate any thoughts that you wanted to share with us – questions, show ideas – that can go to my email address which is in the show notes.