Investing Driving You Crazy? Maybe Its Because You Already Are! (Part 3)

In Part 3 of this series, we will continue on in our analysis of cognitive biases. In Part 2 we discussed anchoring and adjustment, availability and representativeness. In this article we will discuss selective memory, overconfidence and mental accounting.

Overconfidence
Confidence can be a very good thing, but it can also be a very bad thing, especially as it pertains to financial markets and the average investor. In their book, “Why Smart People Make Big Money Mistakes”? Gary Belsky and Thomas Gilovich argue that overconfidence is common and is deeply entrenched. The authors tell us that studies have revealed that most people consistently overrate their ability to make accurate estimates and predictions. For example, 80% of drivers (like us) contend that they are better than "average" drivers. Additionally (surprise, surprise), psychologists have found that people become overconfident when they experience success. There are two main sources of overconfidence bias. Most people tend to underestimate the role of chance in events and thus will erroneously attribute their skill as the defining factor for achieving success. And why not, this feels good. Its easy for us to accept the accolades that come with success, but extremely difficult to accept the blame that comes with failure. It’s usually “some else’s fault.”? This overconfidence was clearly illustrated in the late 1990's where even novice investors experienced exceptional growth in technology stocks. As technology stocks continued to soar, investors began to attribute much of their success to their ability to make wise investment decisions. Instead, they were making horrible choices, forgetting that valuations matter and things are never “different this time.”? How do you avoid this? Study history! Bubbles also occurred with the railroads in the early 1900's, radio broadcasting in the 1920's, and oil and gold stocks in the early 1980's. In every case, investors thought; "This time is different, it's a new economy." Reversion to the mean is a powerful thing.

Selective Memory
Overconfidence is often caused by selective memory. We remember our successes but forget our failures. Its one reason why we usually (if we are willing to open our eyes) learn the most from our failures, not our successes. How does this apply to investing? An investor who remembers only his or her investing successes will likely have built up more (unjustified) confidence than an investor who remembers the effects of all portfolio moves, both good and bad. Selective memory can allows investors to repeat the same mistakes again and again instead of learning a valuable lesson the first time. A good example today (June 2005) is that we seem to have forgotten that profit margins are around 7% (unsustainable), valuations are at levels seen only at market peaks (1900, 1929, 1966, 1987 and late 1990’s) and dividends are near all time low’s. However, this is more of a lack of knowledge of the history of the markets (as most investors only remember the 1980’s and 1990’s, not the late 1960’s and 1970’s) than it is a problem of selective memory.

Mental Accounting
One of my favorites. It relates to a type of call we’ve fielded from clients on more than one occasion. “Why is XYZ Personal Account down over the last few months?”? they might ask. Our reply, “Because XYZ Personal Account holds mostly stock based investments and the overall stock market is down. Look at ABC IRA Account.”? “Well,”? they might reply, “it seems to be performing extremely well, why don’t we switch XYZ so that it looks like ABC?”? They seem to forget that we allocate accounts from a top-down perspective. Holding tax inefficient assets in tax-deferred accounts and tax efficient assets in personal accounts. You MUST look at the big picture. Sure we could diversify each account into a stand-alone portfolio. But is that in the client’s best interest? No, they would end up paying more taxes than necessary!

This is what is called "mental accounting." Mental accounting occurs when investors mentally compartmentalize assets such as stocks, bonds, real estate or accounts (as mentioned above). This causes investors to lose sight of the big picture and instead focus on each specific investment and feel pleasure or pain depending on a particular investment's or account’s performance.