Season Investments

facebook-logo.pngtwitter.pnglinkedin-logo.png

The Cost of Being Human

Posted on May 5, 2015

“Evidence suggests that most investors do considerably worse than they could if they adhered to a few simple principles. And it seems that being human doesn’t help.” – Greg Davies, BarCap

2015-05-05_human.jpgOne of the most interesting things about personal finance and investing is that so many people are eager to accumulate and grow financial wealth, yet they exhibit the exact opposite behaviors needed to do so. The principles that lead to financial gain and long-term investment success are not shrouded in mystery. There is no secret sauce or hidden formula, and in theory it is really quite simple. In theory. We are currently in a series exploring the many different forms of risk we encounter along our financial journey. A wise person once observed, “In theory there is no difference between theory and practice; in practice there is.”* Today we examine how the influence of human emotion often leads to theory being thrown out the window in the financial decision making process, a reality that poses one of the greatest risks to our long-term financial well-being.

We’ve all heard the rules of thumb: live within your means, start saving money early, avoid high interest debt, invest your long-term wealth into a diversified portfolio, buy low and sell high through periodic rebalancing, etc. There are few among us who are not familiar with these and many other sound financial principles, yet there are equally few among us who practice them consistently. One of the shortfalls of financial theory is that it assumes humans can apply such principles with unwavering discipline. It assumes methodical behavior rooted in rationality and a long-term perspective, and it discounts the fact that often times what is the most optimal long-term decision can be hard to live with in the short-term.

This dynamic comes to bear in our day to day financial habits. For instance, despite the fact that proactively saving money is an essential first step in anyone’s financial plan, the delayed gratification required to do so is too high of a hurdle for most people to clear. Not only do we have a hard time saving money, as a society we have a hard time not slipping beneath layers upon layers of high interest debt in order to maximize how much we can consume in the here and now. It just feels good to fulfill our wants and desires as quickly as possible, whereas we have a hard time connecting emotionally to the long-term benefits of socking money away for the future.

Human emotion is also prevalent, and perhaps more so, in the realm of investing where the gap between theory and practice is quite impressive. As a finance graduate and CFA charterholder I’ve dedicated literally thousands of hours of my life to mastering the body of knowledge pertaining to portfolio management. Based on what I’ve learned there are countless principles and disciplines that, if applied robotically, should lead to successful outcomes in a portfolio over a long enough period of time. However, as Greg Davies of Barclays Capital points out in his study Overcoming The Cost Of Being Human,

None of us lives in the long term. We all, to our perpetual discomfort, live in the present, in what we call the zone of anxiety where we are always buffeted – financial and emotionally – by short-term uncertainty.

In an area of life where thinking long-term is essential, we are tossed to and fro by short-term developments in our financial world. The chart below depicts how different these two perspectives can be. The black line shows the annualized return of the S&P 500 (dividends not included) over a rolling 10-year period dating back to the early 1970’s. Notice the line is relatively smooth and spends most of its time in positive territory. The green line, in contrast, measures a rolling 1-year return and flops wildly around from extreme to extreme. One day you could be sitting on a 60% return, and just twelve months later you might wake up to find your account has been cut in half. It’s easy to see how debilitating a short-term perspective can be to an investor’s state of mind; most of us are simply not wired to withstand that kind of an emotional roller coaster.

2015-05-05_Short_vs_Long_Term.png

Unfortunately this short-term perspective leads to a host of counterproductive behaviors. We are psychologically wired to buy high and sell low. When asset prices are high and climbing we can be lulled into a state of apathy and irrational optimism which can cause us to allow our exposure to these highly priced assets to become outsized. In contrast, when asset prices are low and collapsing we feel panicked and eventually reach a point of capitulation in which we decide to pull the rip cord and stem the losses by selling out altogether. We feel like we just can’t take any more losses. History shows that this behavior is repeated time and again by the retail investor populace.

To illustrate this, the table below displays data compiled by DALBAR in which they study the economic impact of the average mutual fund investor’s timing of buy and sell decisions. Depending on what time period is measured, the gap between the average equity fund investor’s performance and the S&P 500 performance ranges from 1.5-7.4%...annualized. This is confirmed by the findings of the Barclays study mentioned above which concluded, “evidence suggests that the natural behavioral need for emotional comfort across the investing experience costs the average investor around 3% per year in foregone investment return.” This is the cost of being human.

2015-05-05_Dalbar_Table.png

I have seen the effects of this truth surface time and time again in my 13 years in this profession, but it is most apparent in extreme circumstances. In Goldilocks environments when things are not too hot and not too cold I notice that conversations tend to be level-headed, thoughtful and open. However, when circumstances tend towards an extreme – and especially when they are extremely negative – emotion almost always takes the wheel and begins driving decisions. I even notice this in myself despite a fairly extensive education and a personality that tends towards being pretty “even-keeled” emotionally (my wife might argue I could stand to show a little more emotion from time to time). My business partner, a product of Stanford’s school of engineering, a fellow CFA charterholder and a Spock-like decision maker, would say the same thing. So if we see these tendencies even in ourselves, why do we expect anything different from our clients who have less of an academic grasp on the history and function of capital markets?

We don’t.

The desire for emotional comfort and peace of mind is an inherently human characteristic. We recently met with a prospective client who saw his retirement portfolio fall by over 60% in the financial crisis. This individual is months away from retirement and is now paralyzed by how to move forward showing that the emotional damage incurred in a massive loss of capital can stick with a person for a long period of time, perhaps even the rest of their lives. By the way, his “advisor’s” response during that rough patch was that he couldn’t do anything about the market and to “just think long-term”. Nice theory.

Far be it from us to judge another person for not acting like a robot, and shame on our industry for expecting its clientele to live through the nauseous days and sleepless nights that accompany the types of market losses seen in the tech bubble collapse and financial crisis. Going back to Greg Davies and the Barclays study, the conclusion from their research is surprising but elegantly obvious.

This may sound strange but by focusing on something other than long-run financial efficiency, we are actually able to get closer to it.

This is perhaps one of the most important insights for us to grasp as investment advisors. There is a true cost of being human, and rather than trying to stifle natural emotional responses we should account for them on the front end and plan accordingly. This is why we put such a high degree of emphasis on proactive risk management. Achieving true diversification and using trend-following indicators to get out of the market during major collapses are two of the primary approaches we take to prevent our clients from living through the types of portfolio declines they may have experienced in the past. We also try to understand the unique makeup of each client and tailor their investment policy in a way that they are most likely to be comfortable with over full market cycles.

We are not saying that theory should be completely set aside. We will always put a high premium on education and understanding, and we will challenge ourselves and our clients to think and act rationally even in the face of uncertainty. However, accounting for human emotion from day one is in and of itself an extremely rational thing to do. The cost of being human represents a risk, and to treat it as such our strategies need to be “anxiety-adjusted” based on the temperament of each client. In doing so, long-run results are more likely to be maximized and we and our clients will be happier humans along the way.

*I’ve always thought it was Yogi Berra who said this, but apparently there is some debate over its actual origination.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


Subscribe to our Weekly Insight via email!

 


Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.