Discipline Matters

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
- Warren Buffett

 

At Flat Fee Portfolios, we believe that disciplined investing matters. A disciplined investor looks beyond the concerns of today to the long-term growth potential of markets. Historically markets have rewarded long-term disciplined investing.

Discipline Matters - Relative Investor Performance

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. MSCI data © MSCI 2014, all rights reserved.
Source: Dimensional Fund Advisors

Unfortunately, disciplined investing is not easy. Human nature equips investors with a variety of cognitive biases that can cause costly investment mistakes. Some of the most common investor mistakes include: over-concentrating in a single stock or a specific type of investment, following the latest investment craze, allowing emotion to override reason, and taking too much (or too little) risk with the overall portfolio.

A study by Dalbar confirmed that an investor is often his/her own worst enemy. The study found that while the S&P500 generated annualized returns of 9.1% in period of 1990 to 2010, the average equity fund investor realized only 3.8% over the same period of time. The example below shows how missing only a few days of strong returns can drastically impact overall performance.

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Performance data for January 1970–August 2008 provided by CRSP; performance data for September 2008–December 2013 provided by Bloomberg. S&P data provided by Standard & Poor’s Index Services Group. US bonds and bills data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and  Rex A. Sinquefield).
Source: Dimensional Fund Advisors


Common Biases, Mental Shortcuts, and Behavioral Errors

While nothing can change our human nature, an awareness of these biases can help investors avoid potential pitfalls.

Source: Dimensional Fund Advisors

Anchoring is a bias that causes investors to either hold onto an idea longer than they should, place a disproportionate amount of value on the piece on information they receive, or anchor their perception of value to a specific price point. The inability to fully incorporate new information causes investors to hold onto poor investments longer than they should.

Availability Bias is a mental shortcut in which investors use readily available information and media to make investment decisions, rather than a disciplined research process.

Familiarity Bias reflects an investor’s tendency to invest in the known. Investors may perceive investments they are knowledgeable about as either less risky or more rewarding, and oftentimes both. Typically the tendency manifests itself in investors concentrating their holdings in their own country (a home country bias) or in the stock of their employer.

Herd-Like Behavior reflects the tendency of investors to follow the crowd by chasing the latest investment fad. Driven by greed and fear of missing out, individual investors project past returns into the future and pile in together. The behavior results in investors consistently buying into the most highly valued segments of the market, leading to sub-par results. Herding can also lead to selling at the most inopportune times, making investors their own worst enemy.

Hindsight Bias occurs when events that have occurred in the past look predictable and obvious from the present.  Hindsight bias leads investors to overestimate their ability to discern the likelihood of events occurring in the future, causing overconfidence.

An Inability to Control Emotions is common. Most individual investors are easily controlled by two emotions:  fear and greed. While everyone would like to “buy low and sell high," very often investors, even very intelligent and well-educated investors, do the exact opposite. They, in effect, “buy high and sell low.” Investors would be wise to heed Warren Buffett’s advice to “be fearful when others are greedy and greedy when others are fearful.” Unfortunately, most investors tend to be fearful at the moment of greatest opportunity and greedy at the time of greatest risk.

Source: Dimensional Fund Advisors

Loss-Aversion is an investor’s reluctance to realize a loss. Investors who exhibit loss aversion hold onto losing investments in the hope that they will recover. They may even engage in risk-seeking behavior by “doubling down” on a poor investment in hope of recovering losses faster.

Overconfidence is a cognitive bias that causes investors to err in a number of ways, usually with financially damaging results.  Overconfident investors are frequently over-concentrated in a specific asset class, sector, or stock. They often disregard the risk and seek out confirming evidence while ignoring any contradicting evidence. More times than not, this increased risk taking is punished with losses. Overconfidence can also lead to increased trading which may result in excessive taxes and fees.

Recency/Vividness Bias reflects a tendency to focus on events that are most recent or easiest to recall because they left a psychological impact.  In investing, the event is typically a recent market correction or recent run-up.  Since the events are recent or vivid, the tendency is for investors to overestimate the likelihood of the event occurring again and position the portfolio either too conservatively or too aggressively.

A Status-Quo Bias is inertia, or a lack of decision making. In many cases, this is because investors seek to minimize their regret. By maintaining the status quo, they avoid the mental anguish associated with realizing an adverse outcome after making a decision. For example, a regrettable event would be a market rally after selling out of equities or market correction after investing in equities. Unfortunately, this bias can result in investors maintaining the status quo with investment portfolios that are not suited to meet their goals and objectives.