Cass Sunstein, in a recent Bloomberg article in which he examined the causes of his own personal investing mistakes, reminisced about a dumb selling decision that he made in 2011. Putting himself on the couch to figure out what he did wrong, Sunstein came up with three reasons to explain why he brashly chose to sell something on a whim:
“Of the behavioral mistakes to which I fell victim, the first is called “availability bias.” Behavioral scientists have shown that if something has happened in the recent past, it is cognitively “available,” and people tend to exaggerate the probability that it will happen in the future.
Availability bias isn’t exactly irrational, but it can produce big mistakes. The stock market did collapse in 2008, but it doesn’t collapse very often, and in 2011 I shouldn’t have focused on the risk of another meltdown.
The second mistake involves “loss aversion.” People tend to hate losses from the status quo – in fact, they hate them far more than they like equivalent gains. If you suddenly lose $10,000, the distress you would feel would almost certainly be greater than the joy you would feel if you suddenly gained $10,000.
The irony is that if we make our decisions on the basis of loss aversion, we’ll end up as big losers. A case in point: As the stock market started to fall, I wanted to prevent losses, and as a result, I lost a lot.
The third bias is called “probability neglect.” Human beings tend to focus on worst-case scenarios, especially when their emotions are running high, and not on the likelihood that such scenarios will actually come about. When I made my stupid decision, the worst-case scenario (another collapse!) loomed large. I devoted far too little attention to the question of whether it was probable.”
Availability bias. Loss aversion. Probability neglect. If you can keep those three psychological factors at the forefront of your mind when crafting a portfolio, you will become one of the top 1% of investors who ever lived (heck, the fact that you’re focusing on the performances and valuations of the businesses themselves, rather than hunches about where the “price might go”, already puts you in that category). The skill set to overcome those three factors is a major ingredient in the transition from good investor to great investor.
On the topic of availability bias, a good recent example would be the performance of Wal-Mart stock. If you’ve been a student of the company’s history, you know that the giant grocer has been giving investors 10-18% dividend increases every year for the better part of four decades. If you’ve actually held the stock for a good chunk of that time, there is a very good chance that you could be reading this post from a beachside resort in Hawaii. Even if you didn’t hop on board until 1985, a point at which Sam Walton was already a household name and had built the family fortune into a source of billion-dollar wealth, you still could have turned ever $15,000 invested into a cool $1,000,000.
Despite this very good long-term record, some long-term Wal-Mart investors have been bumming because Wal-Mart’s Board only granted a 2% dividend increase for 2014. On some levels, I get it. It’s understandable that you’d wonder, “What’s up?” when a blue-chip with a great record gives a meager increase during what is considered the favorable curve of the business cycle. It’s like this is a 2% increase in 2009, which would have been perfectly welcome without anyone batting an eye.
But what getting worried about Wal-Mart’s dividend right now ignores is the fact that the company is increasing its store count from 11,400 to over 12,000 in the coming twelve months. That sucks up a lot of free cash flow. When you receive a lower-than-expected dividend increase because the company is using its cash to organically grow the business, it’s not something to worry about. It’s the reason why you have a diversified portfolio so that the things like Pepsi’s unexpected yet pleasant 15% dividend increase this year can blend together with Wal-Mart’s 2% increase this year to give you nice cash-in-hand growth on the whole.
In short, availability bias is destructive because it caters to our unrealistic expectation to expect businesses to grow at 10% every year and give us 10% dividend raises every year. The business cycle doesn’t work like that. Even in good years, capital expenditures need to be made to build for the future. Wal-Mart shareholders are going to do just fine over the next five to ten years on an earnings growth basis, and worrying about the recent 2% increase is the kind of folly that availability bias creates if you’re not careful to guard against it.
The second thing that Sunstein talks about is “loss aversion”, which is a very real overpowering psychological trait. One of the most basic needs that people have is a desire to constantly feel like we’re moving forward or advancing towards something with life. Depression, violent emotion, dissatisfaction, and all those emotions we want to avoid are best kept at bay when you can structure your life in such a way that you feel closer to your goals at 11:00 PM than you did when you woke up that morning at 8:00 AM.
The power of this psychological force is one of the reasons why I have a website dedicated to writing about dividend investing (the other reason being that cash is, well, awesome. Stuff we want costs money, so it makes sense to create a life that generates it naturally). It’s almost impossible to create a portfolio that naturally ticks forward in portfolio value every year, unless you have a steadily growing job that allows you to add 10-15% to your portfolio value every 12 months. The nature of the stock market is that about one out of every three years the price of the major indices decline. Getting upset at seeing $300,000 turn into $225,000 is a recipe for long-term restlessness, so the answer is this: if you don’t like the game, change its terms. It’s very easy to construct a portfolio of companies that have been raising their dividends for 25+ years and will give you at least 6-7% annual growth if you reinvest the dividends. You’re not going to find too many buy-and-hold dividend investors out in the wild complaining that their 2014 dividend income was lower than their 2013 dividend income. Psychological satisfaction often gets the “Oh, come off it” treatment, but I’d rather harness emotions than discount them.
“Probability neglect” is the last impulse that Sunstein mentions. To get good at making decisions, you have to think in terms of expected payoff. You do this by multiplying the reward (or hardship) against the likelihood of that actually occurring. The temptation is to unduly focus on the reward itself. It’s why people get more excited about a $100 million Powerball lottery than a $25,000 Bingo Night prize at the Veteran’s Hall, even though the second should be greatly preferable once you adjust for the actual odds of winning.
A lot of investor cavailiarly dismiss these risks, saying things like, “I’m not an emotional investor” or “Yeah, I think for the long-term.” Some of them are telling the truth, others are falling victim to Charlie Munger’s warning, “Never try to fool others, and remember, who you see in the mirror is the easiest person to fool.” If you know that certain emotional tendencies affect your decision-making, seek to harness them or mitigate the worst-case scenario risks they pose. It’s a much better strategy than pretending that they don’t exist.
Originally posted 2014-04-11 09:56:53.