Commentary: Decision Making
Updated: Oct 5, 2022
Market declines and recessions are a normal course of financial life and have been repeating on a sporadic basis since the beginning of recorded history. Our contention is that there is no reason to throw out our plans because there are bumps in the road. In fact, our plan is built with the expectation that bumps in the road exist.
"Investing isn't about beating others at their game. It's about controlling yourself at your own game." - Jason Zweig
Dear Family, Friends, and Clients:
If I had a Magic 8 Ball and I were inclined to consult it regarding an impending recession, the romantic in me hopes it would declare “Cannot predict now”. The more important question, and the one that we can answer, is whether or not we should make large changes to your investment portfolio in anticipation of unknown future potentialities. To this question: “My sources say no”.
Recessions are a normal course of financial life and have been repeating on a sporadic basis since the beginning of recorded history. They happen to us individually as well as collectively. Some years are better than others. It is said that a recession is when your neighbor loses his job, and a depression is when you lose yours. Market declines are also common. Unfortunately, the past decade has built a false sense of confidence that stocks always rise, and that investing is easy. Our contention is that there is no reason to throw out our plans because there are bumps in the road. In fact, our plan is built with the expectation that bumps in the road exist.
While the hare roams frantically about, able to cover great distance due to his speed, we rest soundly knowing that we are not in a race, and that if there were a finish line it would be decades or centuries in the future when our current wealth can comfortably be exhausted. We know that the average hare expires after 3 years, while a tortoise can continue “running” for 150 years. The hare is no matter to us; many will come and go during our time horizon. In the present, we make good, well-thought decisions, and we follow our principles to ensure that minor bumps do not cause catastrophic failures.
Interest rates have risen significantly on the front-end of the curve (1-3 years) and we are taking advantage of these rates with assets that we previously held in cash specifically in anticipation of such a rate increase. Our stock portfolio currently yields 8.5% on an earnings basis and is available at a 40% discount to calculated fair value. While this would have been a compelling value given the interest rates prevalent six months ago, the increase in rates has made us less hasty to direct more capital to equities, and we are continuing to be patient as prices decline. If prices continue to drop, we will begin to allocate more capital to equities at a measured pace.
There is no reliable method for predicting price fluctuations in publicly traded securities or transitory spikes and drops in interest rates. We do not buy stocks as volatile squiggles on charts; we buy them as small shares in operating businesses. We buy bonds for income. Our care and diligence in following our principles over the past few years have provided us with a much smoother journey than the average 60/40 portfolio, which as of this writing is down 22.24% year-to-date. If the general economy worsens, our equity securities will see declines just like the others. As Warren Buffett has said, “A rising tide lifts all boats, but you can tell who has been swimming naked when the tide goes out”. Securities that were untethered from reality will likely suffer much worse losses than those that were fairly valued in relation to business fundamentals, and they may take much longer to recover.
It is a mistake to judge individual components of your portfolio in isolation. As Harry Markowitz, the father of Modern Portfolio Theory, said, “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.” Not all of these contingencies happen at once, and they are not mutually exclusive. You may have a security that is down 10% because the price of oil has dropped, or a bond that is showing a 15% decline because of a temporary rise in interest rates, or a precious metal that is down 20% due to rising interest rates, an appreciating dollar, and an impending recessionary threat. The temptation is to sell these things to avoid future losses. This is a mistake because reallocating to investments just because they have been working recently is loading the risk to one side of the boat and denying that the future cannot be safely extrapolated from where we stand. We may find that what was up is soon down, and what was down is soon up. Securities do not move in straight lines. They are characterized by significant randomness in the short-term. It is in the long run that our good decisions are rewarded.
We do not try to time the market. While we have had success valuing the market over the past decade, timing has never been a skill of ours. Diving in and out of investments is an almost certain strategy for poor results. When we try to time the market we almost never sell much before the bottom, and we almost never buy soon enough after it. As Buffett said, “If you wait for the robins, spring will be over”. We are much better off maintaining a balanced approach that attempts to mitigate multiple risks than we are trying to predict the future. Over the past 100 or so years this has been the most consistent methodology of achieving financial success.
Making fast changes in an environment like this is also a mistake. Using the studies of Daniel Kahneman and Amos Tversky, the former who wrote “Thinking, Fast and Slow”, we know that our thought processes are broken down into two systems: System 1 and System 2. System 1 thinking is emotional, and it is based on our instincts; it is much more suited to avoiding impending danger and in situations where time is the most important factor. System 2 is much more introspective; it requires logic and data. It is what allowed us to exit the world of hares and tortoises and build societies. Investment decisions should always be System 2 thinking. The hare uses system 1, the tortoise uses system 2.
In addition to the two systems of thinking, Kahneman and Tversky identified behavioral biases that harm us with faulty decision-making. These biases exist in all areas of life, not just investments. An entire branch of finance aptly titled “Behavioral Finance” has been expanding and refining this list for years. Taking into consideration the recent market volatility, it might be constructive to classify and review our possible behavioral biases and discuss whether these biases should be mitigated, eliminated, or accommodated. As the lead quote suggests, it is ourselves that we are competing against when the market is volatile. To paraphrase Kipling, identifying and mitigating our biases can go a long way toward helping us keep our heads when all about us are losing theirs. If we do not, we only have ourselves to blame.
Behavioral biases are classified into two different categories: Cognitive errors and emotional biases. Cognitive errors stem from faulty reasoning. They can be more easily corrected than emotional biases through education and better utilization of data. Emotional biases on the other hand stem from impulses and utilization of System 1 thinking. They are harder to correct and may require deep self-examination to navigate. Cognitive errors are further broken down into two subcategories: belief perseverance biases and processing errors. Believe perseverance biases are caused by our stubbornness to change our opinions. This causes us to misuse statistics and make errors of memory. Processing errors occur when we use logic incorrectly or irrationally leading to poor financial decisions.
Belief Perseverance Biases:
Conservatism Bias- This bias exists when we refuse to revise our expectations upon receiving new data. We overweight the importance of previous data, even when new data starts to change the probability that our current belief is less likely or wrong. For instance, we have decided that a stock is a good investment based on previous data, but we continue to hold this opinion even as fundamentals begin to deteriorate. In order to overcome this bias, we need to be in the habit of reforming our opinions when new data is available instead of forcing data to completely disprove an existing conviction.
Confirmation Bias- This bias is present when we actively seek information that confirms our existing beliefs, and we discard information that contradicts an existing opinion. It is a matter of accept or decline vs a weighting issue. Some people exhibit this bias when it comes to their choice of news sources and social media content. They build echo chambers for themselves filled with people who agree with them, and they actively shout down counter opinions as misinformation. This bias exists just as prevalently in making financial decisions. We may only read “bullish” articles when we are feeling optimistic, and we may discount “bearish” articles as overly pessimistic. The more evidence we find that confirms our opinions, the more convicted we become. We should judge all information in relation to the truth, and we should seek a balanced narrative that allows us to change opinions when we are wrong- actively seeking out those who disagree with us. It is very hard to prove a thing is true, but it only takes one piece of information to prove a thing false.
Representativeness Bias- This bias affects the way we classify data. We build simple models in our heads, and when new data is available, we may confuse similarity with relevance to the probability of an outcome. Just because parallels exist between objects and events does not mean that there is a causative relationship between them. There are two types of representativeness bias: base-rate neglect and sample-size neglect.
Base-rate neglect: is when we neglect to evaluate an incident’s rate of occurrence in a large population because of specific information that may be misleading at first glance. For instance, all market declines throughout history in the United States have eventually recovered and surpassed the previous highs. We may feel that this time is different and that the value of stocks will go to $0, however this is highly unlikely given the past history or base-rate.
Sample-size neglect: is when we make assumptions about the larger population based on a small sample size. For instance, only 1-2% of humans have red hair, but people of Irish descent make up most of these individuals. If we were in Ireland, we may falsely assume that 10-30% of people have red hair based on our limited sample.
To overcome representativeness bias we need to be certain that we are calculating true population probabilities and that we are not taking a small sample and extrapolating results that are unlikely.
Illusion of Control Bias- This bias makes us feel like we are in control of our destiny. We establish connections that do not exist, and we have great confidence that we can predict the future when the future is unpredictable. For instance, being certain that a recession is impending, or that oil will go up or down. People will pay 4x more for a lottery ticket when they get to pick the numbers even though the odds of winning are the same. This bias causes us to not adequately diversify our portfolios, to make indiscriminate decisions to buy or sell securities, and to build models that are overly intricate. We must remember the future is uncertain and that we are dealing with probabilities not certainties. We need to build portfolios that will perform well in multiple scenarios, knowing that not all securities will go up at the same time once the future is revealed.
Hindsight Bias- This bias makes us feel like past outcomes were certain once we know what happened. We feel like we should have bought more of stock XYZ because it was obviously going to go up, and ABC was clearly going to go down, so we should have sold it. We look at the past and focus on pieces of data that corroborated the then unknown outcome. We must remember that good decisions do not always earn good short-term results. We have to document our decision-making process so that we can truly judge whether future outcomes are bad luck or bad decision-making. (See decision matrix below)
Anchoring and Adjustment Bias- This bias occurs when we use an initial piece of data to form our future judgements and opinions. For instance, if we are looking to buy a used piece of furniture, and the seller says “$500”, we use that number to anchor our counteroffer. Many studies have shown that the first number thrown out in a negotiation anchors the remaining offers, so we should always speak first. We need to make sure that we are utilizing true data when making decisions, not anchoring ourselves to unrealistic initial figures, and we need to update our estimates as time passes. We cannot rely on a high-water mark in a security or an index to inform a buying decision. If prices change with circumstances, previous data becomes unreliable.
Mental Accounting Bias- This bias is when we evaluate our portfolio as a series of accounts that each satisfy different goals. Instead of thinking of our portfolio as a single pool of assets we build overlapping allocations that do not adequately evaluate risk and return. This causes us to have unnecessary correlations among assets, we separate returns from capital appreciation and income, and we treat principle different than gains (play with house money). In order to counter this bias, we should look at our portfolio at the top level instead of managing individual accounts in isolation. The biggest cause of this is having many different advisors managing separate uncoordinated pools of assets.
Framing Bias- This bias is when we answer a question differently based on how the question is worded or framed. For instance, hearing that an investment has a 40% chance of success may sound optimistic, however, if framed as a 60% chance of loss we may be much less likely to pursue this investment. This bias causes us to focus on short-term results and it may cause us to misclassify our tolerance for risk depending on if the discovery process focused on gains or losses. We should not focus on past gains and losses when thinking about our allocations. We should only be concerned with the future prospects for returns and be neutral when evaluating short-term results. As Charlie Munger has said, “Invert, always invert”.
Availability Bias- This bias causes us to miscalculate odds of success based on how easily information is recalled. There are different forms of availability bias, but four common types are:
Retrievability: We implement the solutions that come to mind most easily, even if not accurate.
Categorization: We look for solutions using data that is improperly categorized due to the difficulty in creating new data classes. We may use an old class of data that was relevant to a past decision that is no longer applicable to the current decision.
Narrow Range of Experience: We make decisions based on what data we have that may not be relevant to new possibilities.
Resonance: We make decisions that are consistent with our own experience instead of basing the decision on a more robust set of history.
Loss-Aversion Bias- This bias causes us to work much harder to avoid losses than we work to achieve gains. In other words, we play not to lose. We hold that stock that we bought because our brother-in-law swore it was going to the moon. Here it sits in our portfolio, 7 years later, showing a 57% loss, and everyone knows “it isn’t a loss until you sell”. This bias causes us to allow risk to creep up incrementally because we sell our gains much too soon and we hold our losses in perpetuity. In order to mitigate this bias, we need to have a balanced approach to portfolio analysis, and we need to make all decisions based on fundamentals. As John Maynard Keynes may have said: “when the facts change, I change my mind, what do you do, sir?”
Overconfidence Bias- This bias causes us to allow our confidence to exceed our competence. It is also related to another defect, Self-Attribution bias which causes us to take credit for our successes and blame others for our failures. When the market goes up, that’s just good stock pickin’, but when the market goes down Chairman Powell is clearly to blame. These biases together cause us to underestimate risk and overestimate returns and to hold portfolios that are inadequately diversified. Over-confidence bias comes in two flavors, Prediction Overconfidence and Certainty Overconfidence:
Prediction Overconfidence: is when we assign too narrow of a range to future outcomes. This causes us to underestimate future volatility. We project that the return on a bond will be between 10% and -10%, when it turns out to be -30%.
Certainty Overconfidence: is when we assign probabilities of success to future events that are too high.
In order to mitigate this bias, we need to evaluate both our successes and our failures; we also need to take credit for both. We should look at past failures and try to identify patterns that may incorporate other biases that can further be mitigated to better our process. The following matrix can help in reviewing past decision making:
Self-Control Bias- This bias causes us to act irrationally in the short-term at the expense of reaching our future goals. This is usually in the form of spending money that will be needed to fund the future, or in taking on too much debt to pull consumption into the present. We should all have a simple budget, a proper savings plan, and an adequate cash reserve. In addition, we should follow a disciplined investment strategy and carefully manage debt; instead, we often we try to accommodate our self-control bias by taking more risk than we can afford.
Status Quo Bias- This bias is most akin to being frozen like a deer in the headlights. When under stress we may freeze and unknowingly hold allocations that are not appropriate for our goals. We may hold securities that were purchased based on inadequate research and our loss aversion combines with status quo to make us sit tight when we should reallocate. This is one of the hardest biases to mitigate but working with an advisor and building trust is the best way to “convert retreat into advance”.
Endowment Bias- This bias causes us to hold an asset in much higher esteem simply because we own it and not based on fundamental data. It is less prevalent with common stocks than it is with a private business, especially one built by an individual over many years. Joe may think his bowling alley is worth $1,000,000, but it only generates $20,000 and he works 60 hours a week. However, it does happen with marketable securities, especially when inherited- it is always hard to sell grandma’s stock. The best way to mitigate endowment bias is to compare the price you are willing to accept to the price others are willing to pay in order to establish some level of reasonableness in your pricing. Unchecked, this bias can cause you to hold securities that are over-valued, concentrated in a single asset class, or may cause your asset allocation to be inappropriate for your goals.
Regret Aversion Bias- This bias causes us to fail to make decisions specifically because we are afraid of the regret of making a bad decision. Losses due to making a decision cause more regret than losses caused by failure to make a decision. It is why we would rather make errors of “omission” than errors of “commission”. This may force us to be too conservative with our assets and may cause us to engage in herding behavior because we want to make decisions that feel safer because everyone else agrees with us. Mitigation of this bias involves following an asset allocation plan and rebalancing without emotion when circumstances change. Not evaluating individual positions in a vacuum can also help.
It should be clear that we navigate a minefield of the mind when trying to make good decisions in both investing, and in life. Our principles, systems, and processes are built to take these biases into account when allocating capital, evaluating securities, and thinking about the future. While there is no way to bat 1.000 in investing, we can get our average up to a point that almost ensures long-term success, even though short-term bumps will occasionally make us feel like we are losing a race. The important thing to remember is that this is not a race that can be won or lost based on hasty decisions built on shoddy data. We must follow a lifelong process that forces us to use System 2 thinking in all decisions.
We will continue to allocate your capital in the manner that we believe most likely leads you to future success. We will define success as your ability to fund your lifestyle in the way that makes you most comfortable, and that leaves behind the legacy that you feel is most appropriate, if any. Ensuring your financial success depends very little upon beating the neighbors for a short period of time, that is the game the hare plays. As tortoises, we keep our eyes on the road and rest when needed; it is going to be a long ride. As always, we thank you for your trust. If any questions arise about our philosophy or process, please contact your advisor or me personally.
W. Allen Wallace, MBA, CFA, CPA/PFS, CFP®
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
The above classification of Behavioral Biases was adapted from the CFA Level I Curriculum. It was written by Michael M. Pompian, CFA, Sunpointe Investments.
Kahneman, D. (2011). Thinking, fast and slow.
Montier, J. (2010). Behavioural investing: A practitioners guide to applying Behavioural Finance. Wiley.