Protecting Your Investments From You

By Ser Jing Chong - September 10, 2012 | Tickers: AAPL, BWLD, ZNGA | 0 Comments

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In the aftermath of financial bubbles, individuals who got burnt badly often want to find villains to flog in public. After the Dotcom bubble burst, analysts like Henry Blodget bore the brunt of the public backlash. As the dust settled after the housing market collapsed during the 08/09 financial crisis, it was the banks like Goldman Sachs and Lehman Brothers who were persecuted by public opinion. However, I find it interesting that there is another very important ‘villain’ who often goes unmentioned in most financial articles - that villain is us. In essence, we can be our worst enemies when it comes to investing and Behavioral Finance can show you why it is so.

In this post, I will attempt to highlight two common behavioral quirks that affect our investing behavior and how we can attempt to minimize its destructive financial effects. As humans, our brains are wired in ways that lends itself into biases which leads almost everyone to fall into mental traps. The only way out would be to implement systematic steps so that we are forced to follow good investing processes and prevent our minds from reeking havoc on our investments.

The Narrative Fallacy

The narrative fallacy is the tendency for us to fall for stories while giving too little weight to the underlying facts. Experiments have proven this. For example:

Participants were given information on the effectiveness of a medical treatment which ranged from 90% to 30%. This percentage is known as the base-rate. They were also given a story, which can be positive, negative, or ambiguous about the outcome of the medical treatment on a particular patient. The participants were then asked if they would undergo the same medical treatment if they had the same disease.

Logically, the participants should have relied on the base-rate information to make their decision. Instead, the results of the experiment showed something entirely different. For participants who were given the base-rate of 30% but was told a positive story of the patient recovering, 78% of that group of participants actually said they wanted to go ahead with the treatment! Conversely, for the group of participants who were given the 90% base-rate but supplied with a negative story of the patient becoming even more ill, only 39% of that group said they will accept the treatment. This is evidence of how anecdotal stories can affect our decision making and make us give less importance to the information that counts – the base-rate.

You might find the above information interesting but think: “How can it hurt us as investors?” Well, we can take a look at Zynga’s (NASDAQ: ZNGA) IPO and how the narrative fallacy might have come into play. When Zynga had its IPO in 16 Dec 2011, the story was that its magnificent revenue growth would deliver profit growth eventually as it was linked to Facebook which had more than 900 million members – this meant Zynga had access to 900 million potential paying customers in the still growing social media landscape. The story was attractive as Zynga’s IPO was many-times oversubscribed. However, the underlying facts tell a very different story; it had lost money in two out of the last three fiscal years. Revenue exploded from $121 million in 2009 to $1.41 billion in 2011 but in the process, Zynga’s losses grew from $52 million to $400 million respectively. When a company reports a deficit in its earnings statement that is 35% of its revenue, investors have to ask themselves some serious questions. Zynga’s stock price has declined by 70% since its IPO and investors who were enamored with its ‘social media story’ had to pay with their wallets.

The way to deal with the problem of the narrative fallacy would be to investigate the facts. Make sure the facts are known before any investing decision is made. For example, before investing in the latest IPO du jour, you can check for the past profitability of the company in its IPO prospectus. Is the company making money? How expensive is the IPO stock price relative to its earnings and sales? An even better option would be to wait for a few years for the company to prove its worth before you sink in your investment dollars.

Action Bias and Short-Term Myopia

Let’s take a quick quiz here:

Assume you know two soccer coaches. Coach A and Coach B. Both their teams had just lost their previous games by a score-line of 4-0. Coach A decides to make 3 changes to his team for the next match while Coach B fields the exact same team. Both teams lose again, this time by a score of 3-0. Who do you think would feel more regret, Coach A or Coach B?

Participants were divided into three groups in a study and were given the statement above in different forms. The first group received the exact same statement as above – that is, both teams had lost in the previous matches; the second group only knew that 3 changes were made by Coach A and Coach B made no changes to his team – no information was given about the teams’ previous matches; the third group was given information that both teams had won their previous matches instead of losing 4-0.

As it turns out, 90% of the participants in the third group felt that Coach A would feel more regret after making the changes. However, 70% of the participants in the first group felt that Coach B would feel more regret. Their rationale was that Coach B felt more regret because his team might not have lost twice in a row if he made changes to the team.

When faced with a loss, the urge to make an action or a change to the current status quo is very strong – thus, an action bias.

This can be dangerous to investing because our minds are wired for action. Price volatility in the stock market would certainly mean that your portfolio might be in the red for days in a row or even weeks and this increases our urge to make an action – in this case, to sell the stocks on short-term fluctuations in the hope of seeing gains in new purchases.  Frequent trading has been shown in studies to lead to poorer returns than investors who hold stocks for longer time periods.

We also tend to suffer from information overload which can cause us to miss the big picture – hence the short term myopia. One very well-known experiment involving participants watching a video of basketball players will highlight how the human brain can suffer from inattentional blindness, focus too much on the details and miss what is really important. In the experiment, the participants are supposed to watch a video of two teams playing a basketball match against each other. The teams were dressed in white and black and the participants were told to count how many passes were made by the white team. During the video, a man dressed in a black gorilla suit actually walked into the frame of the video, posed, and exited the frame. You’ll have to see it yourself – what’s surprising is that 60% of participants failed to spot the gorilla! 

In the financial markets, there are snippets of news being created all the time. More often than not, this news would not materially impact companies’ fundamentals but because of their prevalence and the speed at which they are generated, investors sometimes get so caught up in the nitty-gritty details that they overlook what is truly important – just like what happened to the participants in the video experiment.

Using examples of  real-life situations, during Apple’s (NASDAQ: AAPL) most recent earnings report, its share price fell by 4.2% after missing analyst estimates. Investors were probably spooked by a rare earnings miss by Apple. However, people who sold off might have missed the big picture. Apple’s earnings growth came in at 19.6% year-on-year and that growth happened at a time when most of their customers were waiting for the release of the latest iProduct to replace their old ones – that 19.6% is a very healthy growth number! Furthermore, Apple was trading at a PE of 14.6 just before their earnings release for the latest quarter. At such a valuation, the ‘big picture’ would suggest that an earnings report like what Apple had released was actually great news.

Buffalo Wild Wings (NASDAQ: BWLD) was also a victim of short-term myopia by investors. Buffalo Wild Wings are a chain of restaurants selling boldly flavored chicken wings and as you can guess, chicken wings make up a huge component of their costs. Buffalo reported year-on-year sales growth and earnings growth of 30% and 7% respectively. The discrepancy between the earnings and sales growth was due to a spike in chicken wing prices. This spooked investors and caused a sell-off, with Buffalo’s stock price dropping 10.7% in a single day. In this instance, investors seemed to think that chicken wings would be priced at the new, higher price point permanently. The thought that such price increases in chicken wings would most probably be temporal seemed not to have occurred to those involved in the selling. Again, the big picture was missed because Buffalo Wild Wings’ true long-term profitability was still intact and the recent spike in raw material costs is temporary in nature.

One of the best ways to overcome this action bias and short-term myopia would be to have an investment check-list or diary in which the rational for buying and reasons for selling should be clearly stated before any stock is purchased. In that way, any short-term news can be filtered through the checklist to see if it truly impacts the company’s long-term business performance so that knee-jerk reactions brought on by our action-bias can be lessened.

Conclusion

Financial academics and commentators often neglect to mention how investors’ own behavior can harm their portfolio. Mainstream financial knowledge deals with efficient markets and rational human beings, but the fact is, humans are inherently and predictably irrational. Behavioral biases are wired in our brains and cause us to make poor financial decisions. By recognizing the fact that such biases are prevalent in our actions and taking steps to minimize its effects, you can finally protect your precious portfolio from one of your worst enemies: yourself.

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