Life is Understood Backwards…But Lived Forwards…

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We are Value investors which means we believe that successful long-term investing involves buying out of favor securities selling cheap relative to their earnings and assets. Stock prices are a function of many things - earnings, dividends and the level of interest rates – but equally important is human emotions.

Ray DeVoe, a well known market commentator of past decades, summed up the market well, “The stock market is only indirectly related to economics. It is a function of human fear, greed and apprehension, all overlaid on a business cycle.” The reason Value works is people don’t like to be associated with losers and their fear and apprehension has them sell securities even when they are often very undervalued. 

Richard Thaler of the University of Chicago recently won the Nobel Prize for Economics for his work in human behavior and how this affects our decision making process. Although we are rational and logical most of the time, we are also very irrational at other times.  And I mean both the unsophisticated individual investor and the most professional portfolio manager.

Here are some examples of Behavioral Finance in action. First the Endowment Effect.  This is the tendency to value things we already own more highly than those we don’t.  Give people a common coffee cup and ask them to price it and sell it to others. Theory would suggest both buyers and sellers would value a cup fairly similarly.  They don’t. Few mugs sell because the sellers value them far more highly than the buyers. Does this sound familiar? Think of your family heirlooms and the value you ascribe to them or the stocks you own. Owners and non-owners value things very differently.

A second example is anchoring.  A stock does not know you own it. But you know you paid $25 for it even though the price today is $16. You focus on the $25 price. You will often not sell until you get back to your starting point. Maybe it would be better to disregard your purchase price and simply ask, would I buy this stock today or  hold it or sell it? 

A final example is how we value the present versus the future. When you take a new job, HR asks you how much you want to contribute to your retirement plan. Since expenses are high and the future is far away you put down a very small amount or none at all.

Thaler knows that how you frame a  proposition affects the outcome. If the HR Department were to say that unless you tell us differently we are going to put 5% of your salary in the retirement account and then increase this percentage every time you get a wage increase, what do you think would happen? The answer is, participation and overall savings jump significantly. Framing matters.    

Pogo could have been talking about our decision making process when he said, “We have met the enemy and he is us.”