Cognitive Biases: How our brain messes with our investments

As an investment coach I work with individuals, and groups to help them make better investment decisions. This has been achieved by improving their financial literacy and behaviour towards money. While I spend a good part of my time teaching and coaching people on the mechanics of analyzing investments, I find over the years, I have been spending more time coaching people on the emotional and behavioral side of investing. When I started investing in the mid 1990’s, I focussed a lot on the quantitative side. Over the years I started to realize that you can’t just know the mechanics. Ultimately I believe strongly that the emotions and biases we develop will determine our financial success.

I believe that the greatest impediment to making better investment decisions is not a lack of knowledge nor is it a lack of financial information or financial resources or training or education or financial literacy or the Bank of Canada or Obama or the arrogance and insensitivity of the financial services industry.

It is ourselves…more specifically it is our brains that hold us back.

Our brains after we start investing

Our brains after we start investing

It is the stuff between our ears and how it reacts and perceives actions, events, and information that will drive our investing proficiency.

When people start investing, they are excited, motivated, keen, and confident. Unfortunately as they go along the journey they end up feeling confused, frustrated and angry. Why? It is our brains messing with us.

The reality is that our brains and logic are not just wired for investing. It doesn’t matter if you have an MBA, CFP, or CFP or work on Bay Street or Wall Street. We all inherit behavioral traits that can cloud our judgement.  The discipline of Behavioral Finance has evolved over the years to study why people make the investment decisions they do. We all have different levels of bias we inherit and evolve as we grow.

In this series, I would like to review some of the more common behaviors and biases that have emerged. The first behavior we’ll be examining is Herding and Groupthink.

Herding and Groupthink Behaviors

One of our core human traits is a need to be part of something, whether that is a peer or social group or family. By being associated with a group, we feel a certain level of security, comfort, and safety. As humans we are constantly searching for groups to associate with and more specifically, groups that are perceived to be cook, hip, current, and share ideas and beliefs that are similar to ours. We’re all prone to want to be on the winning team. 

In investing, the whole concept of herding and groupthink behaviour is rampant. We tend to frame our investment decisions around stocks or investing strategies that have been performing well or stocks that have become hot or popular.

Probably sums up how most people invest (KAL The Economist)

Probably sums up how most people invest (KAL The Economist)

Within the financial services industry, herding behavior is rampant. It is embedded deeply in the culture because it is beneficial for one’s job security to tow the company’s investment philosophies and strategies. It’s also more politically palatable to support investment decisions that are more conservative in nature. Normally we think of portfolio managers as having carte blanche in deciding what stocks to buy and sell. The reality is many have to get their decisions vetted by a committee and often those steering type committees will err on the side of caution. As a result, it makes it easier for a manager to justify buying a Walmart than buying a Valeant Pharma or Telecom Indonesia. Finally you just don’t want to stick out proposing contrary viewpoints. The culture has a funny way muzzling people down.

Robert Buckland of Citigroup published a report citing that this groupthink and herding behavior plays a prominent role in stock market bubbles we’ve experienced in the past. According to Mr. Buckland,

“A weary client once defined a bubble to as ‘something I get fired for not owning’. It is career threatening for an asset manager to fight a big bubble. For example, the late 1990’s (technology, media, and communications) bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fire many years ago…”

He further goes on to say that, “…bubbles are obvious in hindsight, they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force skeptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these skeptics capitulate, of course they contribute to the bubble and force other skeptics left to capitulate. It makes sense for an asset management company to manage its business risk but this end up contributing to the madness. Through this, the modern fund management is almost hard wired to produce bubbles…”

Herding permeates our personal lives as well as our professional working lives. Peer pressure puts emotion front and centre and can easily cloud our judgement.  It exists in the cocktail and dinner parties. It exists when we’re around our social circle and when we want to project our investing prowess. A lot of our decision making is influenced by the ideologies and thinking of the peer groups we choose to associate with.

Tracking the Herd: Consensus

Herding behaviour also produces consensus thinking. A mindset develops where the peer group is so convinced an event will occur that they will pound the table and be incredibly vocal about their sentiments. Unfortunately consensus thinking never aligns itself with actions that are taking place with stock market.

Why do we as investors care about what the consensus is thinking? We care because consensus thinking and market psychology can be framed over a backdrop of the stock market cycle and often the sentiment at a certain milestones can be quite contrary as the chart below shows. One of the basic rules of investing is to buy low and sell high. When you translate this to the graph, we see that the times we should be buying are in periods where emotions are negative and sentiment is negative while the times we should be selling are in periods where emotions are positive and consensus thinking is positive. The reality is that when we follow the herd mentality we execute investment decisions at precisely the wrong time. We buy high and we sell low. Herd/consensus thinking is essentially contrarian in nature.

If we can recognize these moments in consensus and herding behaviour, they can provide contrarian opportunities to take the other side of the trade and ride the wave up as more often than not, the consensus will fall flat in their prognostications and chest thumping. 

There are many sources and indicators of tracking consensus thinking and below are some of the more well known

  • American Association of Individual Investors publishes a weekly survey of investor sentiment of its members. (http://www.aaii.com/sentimentsurvey)
  • IFIC Monthly Mutual Fund Flows – http://statistics.ific.ca/English/Reports/MonthlyStatistics.asp . This report gives you sense of which asset classes are growing and shrinking.
  • Put/Call Ratio. This indicator gives you a ratio of bullish trades to bearish trades.
  • Consensus of Economists and Money Managers. These Soothsayers are predicting everything from interest rates, to GDP, to unemployment rates.
  • Mainstream Media (Magazine covers, Newspaper covers, Evening News). The basic rule is if economic and business events both good and bad run as lead stories in the media, it can mark a moment of positive or negative consensus.
  • CNN/Money Fear and Greed Index. This index pulls technical stock market data information and aggregates it into an index that gauges the level of giddiness and fear that is permeating the US stock market.
  • Sage Investors – Investor Consensus Blog. Sorry for the shameless plug. We have been blogging when he observe moments of consensus thinking in the stocks, business, economics, and pop culture. We present them in a simple Bull/Bear column format to give you a visual queue of what the consensus is thinking.

The foundation of bad investment decision making behaviour is based on putting too much stock and faith into what a collective group of people feel and think about the stock market. Following the herd and consensus while in alignment with our human needs, can often be the wrong path to take and can have a negative impact on your savings.  Herd behaviour feeds into other cognitive behaviours and biases which negatively impact our investment decision making. We will dive into them in future posts.