Quiz!
Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)
- Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
- Buy well established companies that are not going anywhere.
- Buy obscure small companies that you don’t understand.
- Buy companies you clearly understand.
The Secret to Getting Rich
Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:
|
Good Action |
Bias |
Biased Action / Human Nature |
|
Defer spending to invest, and enjoy compounded growth |
Present Bias |
Emphasize the present over the less tangible future |
|
Invest in fast growing (and volatile) investment classes |
Myopic Loss Aversion |
Avoid declines, even temporary |
|
Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines) |
Recency Bias |
Prefer investments that did best in the recent 5-10 years |
|
Diversify across countries |
Home Bias |
Buy familiar stocks that are close to home |
|
Own small stocks |
Familiarity Bias |
Buy large stocks that are more familiar |
|
Enjoy momentum |
Disposition Effect |
Sell too soon, after seeing a gain, and too late after seeing a loss |
|
Buy small & unknown profitable companies |
Familiarity Bias |
Focus on known profitable companies over less known ones |
A couple of notes about the list above:
- If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
- An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.
If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.
Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:
- Think of tangible examples for the tradeoffs. For example, would you give up spending $10,000/year for the next 20 years, in return for $38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of $521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
- Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
- After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.
Quiz Answer:
Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)
- Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
- Buy well established companies that are not going anywhere. [Correct Answer]
- Buy obscure small companies that you don’t understand.
- Buy companies you clearly understand. [Correct Answer]
Explanations:
- Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
- Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
- As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
- Familiarity Bias. See #2.