“In the 1950s, a young researcher at the RAND Corporation was pondering how much of his retirement fund to allocate to stocks and how much to bonds. An expert in linear programming, he knew that “I should have computed the historical co-variances of the asset class and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it- or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.” The researcher’s name was Harry Markowitz. Several years earlier, he had written an article called “Portfolio Selection” for the Journal of Finance showing exactly how to calculate the tradeoff between risk and return. In 1990, Markowitz shared the Nobel Prize in economics, largely for the mathematical breakthrough that he had been incapable of applying to his own portfolio.”
From Jason Zweig’s excellent book “Your Money and Your Brain”
What does this tell us about managing our own portfolios? If the very guy who invented Modern Portfolio Theory was unable to apply his own theory in his own portfolio, what hope do we have in overcoming our own behavioral/cognitive biases?
Behavioral or Cognitive Biases are incredibly difficult to overcome. A lot of the time we aren’t even aware we are falling prey to them. What are they? Very simply Wikipedia defines them as “tendencies to think in certain ways that can lead to systematic deviations from good judgement”. They are “hard wired” into us and for the most part we are oblivious to them.
Let’s look at two. First - Confirmation Bias. What is that? Almost inadvertently we tend to seek out the opinions of those who agree with us. Do you think Real Estate will keep going up in value? You will tend to seek out opinions/read articles/news stories etc. that support this view and dismiss as misguided those that disagree with you when you should be doing exactly the opposite. You want to be looking for evidence of why you might be wrong versus seeking evidence to support your view.
Here’s a really tough one, the Loss-Aversion Bias. Do you have an investment in your portfolio that is down in value? Do you find yourself not wanting to sell that investment? That is classic Loss-Aversion Bias. You tell yourself that if you sell it, a paper loss turns into a realized loss and you never know, it just might come back (most likely right after you sell it). In reality, you need to be cool-headed and purely subjective with each investment and clearly assess the chance of a recovery versus becoming emotionally attached to an investment. However, this is very hard to do by yourself. We all hate to realize losses. Hope springs eternal.
What can we learn from this? Everyone including Economic Nobel Prize winning professors can benefit from expert advice. Find a seasoned investment advisor (preferably one that is has lived through a couple of bear markets) and have them take a look at your portfolio and see if you are falling prey to any behavioral biases. Two eyes are better than one.
Mike Hayhoe, Canaccord Genuity Wealth Management
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