Be Careful Not to Let Biases Impact Your Decisions
Thursday, September 18, 2014

There is a new study about superstitions and portfolio returns. It should not surprise you to hear that superstitious individual investors have worse performance than those who are not superstitious. Any time biases are introduced into financial decision making, returns will be affected.

The study looked specifically at Taiwanese traders. The researchers found a far higher ratio of orders placed at prices ending in the number eight than they did for orders ending in the number four. This was attributed to the fact that Chinese culture views the number “8” as lucky and the number “4” as unlucky. The researchers noted that in Mandarin, “four” is pronounced similar to “death,” whereas “eight” is pronounced similar to “good fortune.”

Traders who were the most superstitious trailed investors who were the least superstitious on an intraday, one-day and five-day basis. The reason is simple. The superstitious traders let their biases toward certain numbers govern their investing decisions, rather than making purely objective choices.

The study’s authors pulled no punches when discussing the results. They called superstitions “a separate dimension of an investor’s cognitive disability in making financial decisions.”

It’s not fair to solely call out Taiwanese traders for being superstitious. A bias toward or against certain numbers exists in many cultures and religions. Here, in the United States, 13 is viewed as an unlucky number. Some buildings go so far as to rename their 13th floors to avoid having it as an option on elevators, including our own office building. Conversely, 13 is a lucky number in many other countries, as is three. It is not uncommon for a Jewish person to give monetary gifts or make donations in multiples of 18. Based on anecdotal evidence, it seems fairly common for people to use birthdates when choosing lottery ticket numbers.

It has been well-proven that we humans use heuristics when making decisions. Our minds have evolved to seek and identify patterns. Doing so has helped us survive, but it has also left us with biases that lead to incorrect decisions. Scientific American recently wrote about a study showing a chimpanzee outplaying a human competitor in a brain game. 

We’re intellectually superior to chimps in most ways. The downside of our intellect is that we can let our biases interfere with what should be purely rational decisions. As such, you should be careful about letting biases influence your decisions (and generally trying to outthink yourself or the potential actions of others.) For example, it’s not uncommon to see great companies have stocks that are risky or otherwise unappealing investments. On the other hand, just because you don’t like an industry doesn’t mean you should avoid it. The stocks within it might be great investments.

The one exception is social investing. You need to invest in a manner that allows you to sleep at night. If buying shares in a certain company puts you at odds with your morality or other closely held beliefs, don’t do it. Realize, however, that by doing so you restrict the number of investment options available to you and that, in turn, could harm your portfolio’s performance.

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AAII Model Portfolio Update

No changes were made to either portfolio last month. As Jim Cloonan will explain in next month’s AAII Journal, REX American Resources (REX) is being kept even though its price-to-book-value ratio is over the 2.4 maximum. At the time of his quarterly review, all of the qualifying stocks either were either already in the portfolio or were Chinese companies, which are eliminated because of data uncertainty.

The Model Shadow Stock Portfolio’s 6.4% return for August was better than the Vanguard Small Cap Index fund (NAESX), which increased 5.0%, and the DFA US Micro Cap Index fund (DFSCX), which was up 4.5%. For the year, the Model Shadow Stock Portfolio is now up 1.4%, trailing the Vanguard Small Cap Index fund, which is up 6.2%, but beating the DFA US Micro Cap Index fund, which is down 0.1%. The Model Shadow Stock Portfolio has a compound annual return of 17.8% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.4% annually over the same period.

The Model Fund Portfolio climbed 3.6% in August. In comparison, the Vanguard Total Stock Market Index fund (VTSMX) was up 4.2%. For the year, the Model Fund Portfolio is now up 9.6%, ahead of the Vanguard Total Stock Market Index fund, which has gained 9.2%. The Model Fund Portfolio has a compound annual return of 9.6% from inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 9.1% annually over the same time period. 

The Week Ahead

On Thursday, Nike (NKE) will be the first Dow component to report earnings this earnings season. Joining it will be fellow S&P 500 members AutoZone (AZO) on Monday; CarMax (KMX), Bed Bath & Beyond (BBBY) and Carnival Corp. (CCL) on Tuesday; Jabil Circuit (JBL), Paychex (PAYX) and Accenture (ACN) on Wednesday; and Micron Technology (MU) on Thursday.

The week’s first economic report of note will be August existing home sales, released on Monday. Tuesday will feature the PMI Manufacturing Index Flash. August new homes sales will be announced on Wednesday. Thursday will feature August durable goods orders. The University of Michigan’s final September consumer sentiment survey and the final estimate of second-quarter GDP will be released on Friday.

Several Federal Reserve officials will make public appearances: New York president William Dudley and Minneapolis president Narayana Kocherlakota on Monday; Governor Jerome Powell and Kansas City president Esther George on Tuesday; Cleveland president Loretta Mester and Chicago president Charles Evans on Wednesday and Atlanta president Dennis Lockhart on Thursday.

The Treasury Department will auction $29 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday, and $29 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

Optimism among individual investors about the short-term direction of the stock market remained above its long-term average for the sixth consecutive week, according to the latest AAII Sentiment Survey. This is the longest such streak since early January. Neutral sentiment also rose this week, while pessimism declined.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 1.9 percentage points to 42.2%.  The last time bullish sentiment stayed above its historical average of 39.0% for a longer period of time was a seven-week stretch between November 28, 2013, and January 9, 2014.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.8 percentage points to 34.8%. This is the third consecutive week and the 35th out of the past 37 weeks with a neutral sentiment reading above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell by 3.6 points to 23.0%. The drop keeps pessimism below its historical average of 30.5% for the 43rd time in the past 49 weeks.

Keeping many individual investors optimistic about the short-term direction of stock prices is the S&P 500’s overall upward momentum, earnings growth, sustained economic expansion and the Federal Reserve’s tapering of bond purchases. Causing other AAII members to be pessimistic are prevailing valuations, the failure of the S&P 500 to set new highs, events in the Middle East and Ukraine, the pace of economic growth and Washington politics.

This week’s special question asked AAII members what they thought about this year’s increased initial public offering (IPO) activity. Slightly more than 30% of respondents expressed a negative viewpoint, saying it was either a sign of a market top or frothy valuations. At the other end of the spectrum, more than 17% viewed the increase in IPO activity positively. Several of these members said the larger amount of IPO activity was a sign of good economic and/or business conditions. Nearly 21% of respondents said they don’t follow or don’t invest in IPOs.

Here is a sampling of the responses:

  • “It makes me cautious about the future because it might indicate frothiness.”
  • “It’s an indication that we are nearing a market top.”
  • “A vote of confidence for the economy. Companies feel this is a good time to be looking for investors.”
  • “It’s a positive indication of business growth.”
  • “Couldn’t care less. Never invested in an IPO and probably never will.”

This week’s Sentiment Survey results:

Bullish: 42.2%, up 1.9 points
Neutral: 34.8%, up 1.8 points
Bearish: 23%, down 3.6 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!