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Category Archives: confirmation bias

Top Five Investing Articles for Individual Investors Read in 2019

09 Monday Dec 2019

Posted by wmosconi in asset allocation, Average Returns, behavioral finance, beta, bond yields, confirmation bias, correlation, correlation coefficient, economics, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, gross returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, market timing, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, speculation, standard deviation, statistics, stock market, Stock Market Returns, stock prices, stocks, time series, time series data, volatility, Warren Buffett, yield, yield curve, yield curve inversion

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As the end of 2019 looms, I wanted to share a recap of the five most viewed articles I have written over the past year.  The list is in descending order of overall views.  Additionally, I have included the top viewed article of all time on my investing blog.  Individual investors have consistently been coming back to that one article.

1. Before You Take Any Investment, Advice Consider the Source – Version 2.0

Here is a link to the article:

https://latticeworkwealth.com/2019/09/18/investment-advice-cognitive-bias/

This article discusses the fact that even financial professionals have cognitive biases, not just individual investors.  I include myself in the discussion, talk about Warren Buffett, and also give some context around financial market history to understand how and why financial professionals fall victim to these cognitive biases.

2.  How to Become a Successful Long-Term Investor – Understanding Stock Market Returns – 1 of 3

Here is a link to the article:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

It is paramount to remember that you need to understand at least some of the history of stock market returns prior to investing one dollar in stocks.  Without that understanding, you unknowingly set yourself up for constant failure throughout your investing career.

3.  How to Become a Successful Long-Term Investor – Understanding Risk – 2 of 3

Here is a link to the article:

https://latticeworkwealth.com/2019/09/25/successful-long-term-investor-risk/

This second article in the series talks about how to assess your risk for stocks by incorporating what the past history of stock market returns has been.  If you know about the past, you can better prepare yourself for the future and develop a more accurate risk tolerance that will guide you to investing in the proper portfolios of stocks, bonds, cash, and other assets.

4.  Breakthrough Drugs, Anecdotes, and Statistics – Statistics and Time Series Data – 2 of 3

Here is a link to the article:

https://latticeworkwealth.com/2019/11/20/breakthrough-drugs-statistics-and-anecdotes-time-series-statistics/

I go into detail, without getting too granular and focusing on math, about why statistics and time series data can be misused by even financial market professionals.  Additionally, you need to be aware of some of the presentations, articles, and comments that financial professionals use.  If they make these errors, you will be able to take their comments “with a grain of salt”.

5.  Breakthrough Drugs, Anecdotes, and Statistics – Introduction – 1 of 3

Here is a link to the article:

https://latticeworkwealth.com/2019/11/11/breakthrough-drugs-statistics-and-anecdotes-investing/

I kick off this important discussion about the misleading and/or misuse of statistics by the financial media sometimes with an example of the testing done on new drugs.  Once you understand why the FDA includes so many people in its drug trials, you can utilize that thought process when you are bombarded with information from the print and television financial media.  Oftentimes, the statistics cited are truly just anecdotal and offer you absolutely no guidance on how to invest.

                                       Top of All Time

Are Your Financial Advisor’s Fees Reasonable?  Here is a Unique Way to Look at What Clients Pay For

Here is a link to the article:

https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/

This article gets the most views and is quite possibly the most controversial.  Individual investors compliment me on its contents while Financial Advisors have lots of complaints.  Keep in mind that my overall goal with this investing blog is to provide individual investors with information that can be used.  Many times though, the information is something that some in the financial industry would rather not talk about.

The basic premise is to remember that, when it comes to investing fees, you need to start with the realization that you have the money going into your investment portfolio to begin with.  Your first option would be to simply keep it in a checking or savings account.  It is very common to be charged a financial advisory fee based upon the total amount in your brokerage account and the most common is 1%.  For example, if you have $250,000 in all, your annual fee would be $2,500 ($250,000 * 1%).

But at the end of the day, the value provided by your investment advisory is how much your brokerage account will grow in the absence of what you can already do yourself.  Essentially you divide your fee by the increase in your brokerage account that year.  Going back to the same example, if your account increases by $20,000 during the year, your actual annual fee based upon the value of the advice you receive is 12.5% ($2,500 divided by $20,000).  And yes, this way of looking at investing fees is unique and doesn’t always sit well with some financial professionals.

In summary and in reference to the entire list, I hope you enjoy this list of articles from the past year.  If you have any investing topics that would be beneficial to cover in 2020, please feel free to leave the suggestions in the comments.

Before You Take Any Investment Advice, Consider the Source – Version 2.0

18 Wednesday Sep 2019

Posted by wmosconi in asset allocation, Average Returns, behavioral finance, bonds, Charlie Munger, confirmation bias, Consumer Finance, emerging markets, Fama, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, interest rates, Internet Bubble, investing, investing advice, investing, investments, stocks, bonds, asset allocation, portfolio, investment advice, investments, Markowitz, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Uncategorized, Valuation, volatility, Warren Buffett

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I originally wrote about this topic five years ago.  However, I think that it may even be more relevant today.  You may have heard about behavioral finance/economics and how cognitive biases plagued individual investors when making financial and investing decisions especially during volatility times in the financial markets.

Sometimes an overlooked topic is the fact that whomever provides you with financial advice will invariably be affected by those same biases.  Yes, even the professionals cannot escape them.  One of the most prevalent and insidious cognitive biases is called “anchoring”.

In layman’s terms, “anchoring” describes the tendency of people to form a particular belief and then stick with it unless there is an incredible amount of evidence to the contrary.  It is just part of human nature; we generally do not want to admit that we were mistaken or flat out wrong.

Now when I am talking about considering the source, I am not referring to the person’s qualifications such as having a Chartered Financial Analyst (CFA), Certified Financial Planner (CFP), or Chartered Market Technician (CMT) designation.  I am referring to the person’s investing paradigm. 

For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry.  The first several of years have an outsized impact on their investing recommendations throughout the rest of their careers. 

I will give you an example in life, and then I will talk about Warren Buffett and even myself.  Take special note that I am including myself in this “anchoring” cognitive bias within the context of investing.

There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music.  For example, there are many people in their early 40’s that love 80’s rock.  They would prefer to listen to that over any type of new music.  My parents are in their seventies now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, Motown, and lots of one-hit wonders from the 50’s and 60’s. 

Think about your own taste in music.  Does this ring a bell?  Most people fall into this category, and it is almost subconscious.  You like a certain genre of music best, and it sticks with you.  Did you have a family member that was really into music and had a collection of records?  Sometimes you get introduced to music at an even younger age, and you are drawn to it.  You listened to it during your formative years.  The same goes for investing in a rather similar way.

If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously.  Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics.  The themes in the book seemed to resonate with him.  I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them.  The rest of the classmates just sat back and enjoyed the “show”. 

Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher.  Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits.  “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing.  This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.

Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style.  Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.

I did not pick Warren Buffett because of his long-term track record of stellar performance.  I only picked him because many individuals are familiar with Warren Buffett.  Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951.  If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929.  The baby boom was in full swing, and the US economy was on overdrive in terms of growth.  The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle. 

There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent.  Well, there were still scams, but they were harder to pull off.  (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago).  Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could.  In fact, Buffett used to read entire books on every single public company. 

During that time period, information was so disjointed and hard to get.  However, it was now available to the public and professional investors who could do much more thorough analyses.  The financial markets had far more inefficiencies back then. 

This time period was before the dawn of Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM), and the Efficient Market Hypothesis (EMT).  Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.

Buffett started his own investment partnership in the mid 50’s.  It was essentially a hedge fund in most respects.  Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969.  The stock market at this time seemed to be overpriced in his estimation, so Buffett disbanded the partnership.  He referred his partners to Bill Ruane of the famed Sequoia Fund.  Bill was a former classmate of Warren, and he amassed quite a record himself.

So if we look at Buffett’s beginning career, he saw how doing your homework really paid off.  In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy.  After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on. 

Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment.  Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing.  These formative years are still with Buffett. 

Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well.  What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period.  This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.

Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987.  What got me so interested in the stock market?  Obviously Black Monday on October 19, 1987 really caught my attention.  It was not really the crash that really piqued my interest though.  My father told me that the market drop of 508 points on that day was an overreaction (down over 20% amazed me).  I did not know much about stocks, but it seemed to me like the world was ending.  At least that was how the nightly news portrayed things.  My father said watch the market over the next several days. 

To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions.  Wow!  This turn of events was really weird to me.  How could stocks move around in value so greatly?

I thought that all the big money investors in the stock market really knew what they were doing.  However, most everyone was caught by surprise by Black Monday.  The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA.  If you want to get your friend’s attention, you can ask them what the return of the DJIA was for 1987 (positive return) and 1988 (negative return).  Most people will get it wrong.

Well, these events left a mark on me.  When I learned more about investing and was exposed to Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMT), I really did not think it was true given my start in investing back in the latter portion of 1987.  How could the value of the entire U.S. economy be worth 20% less after one day of trading? 

Now, the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door.  Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market. 

For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market.  I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems.  I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros.  Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam. 

The CFA is now the standard designation for all portfolio managers of stocks and bonds.  I tried studying for it, but a lot of it made little sense to me.  I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.

Most of the financial professionals you meet will range in age from twenties to sixties.  You should always ask them when they started investing or their career as a Financial Advisor.  Here are the ten major events that will cover those individuals:

  • The 1973-1974 severe bear market;
  • The Death of Equities article from Business Week magazine in 1979;
  • Black Monday in October 1987;
  • The Bond Bubble Bursting in 1994;
  • The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;
  • The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;
  • The Bursting of the Internet Bubble in April 2001;
  • The Financial Crisis and ensuing Great Recession of 2008-2009;
  • The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.
  • Managing Money is Easy. Look at my investing record over the past 10 years (2009-2018).  Note that the annualized return of the S&P 500 index over that period was 13.13%.

These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation.  In fact, I met a Financial Advisor that tells his clients that they can expect to earn 12% annually from stocks over the long term.  He uses this return for modeling how much clients need to invest for retirement.  He was introduced to investing around 1996 which is when the stock market went gangbusters. 

I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks.  He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement.  He started advising clients in 2007, and he lost a great many clients in 2008.  Therefore, he wants to have limited downside risk for two reasons. 

First, he has seen how much the stock market can drop in one year.  Second, this gentleman wants to ensure that his clients do not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.

The importance today of the long, extended bull market of the past 10 years is extremely important to take into account for all individual investors.  A recent stretch of 13.13% annualized stock returns makes it seem that investing systematically over the long term is the correct investment strategy.  I would not disagree with that thought. 

However, Financial Advisors with 10 years of experience or less will only tell clients what they would do hypothetically in the event of a major market decline in the stock and bond markets.  Hypotheticals and backtesting are all well and good. 

But it has been my experience, that there is no substitute for actually investing during periods of extreme volatility and major stock market declines (20% or more).  For example, what was the best stock investment strategy right after the Internet Bubble implosion in terms of the asset class?  The best performing asset class for the next decade was to have a larger than normal allocation to emerging market stocks (think Ticker Symbol EEM or VWO).  Do you think that your Financial Advisor would have the stomach to recommend this investment to you after seeing the NASDAQ index fall by over 50%?

As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly.  I am not saying that any of this advice is “wrong” per se. 

My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with.  Thus, you can refer to the aforementioned list of ten major events in the history of the financial markets.  These events really shape the investment paradigm of all of us.  And, of course, I will admit that I am no different.

With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals first few years with the financial markets.  Some financial professionals are more bullish than others.  Others focus on downside risk and limiting volatility in investment portfolios.  Still others utilize complicated mathematics to build investment portfolios that are optimized. 

Therefore, you need to understand your risk tolerance and financial goals very well.  You have your own personal experience with the market.  If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful. 

History does repeat itself, but the repeating events will be caused by much different factors in most cases.  Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a whole host of other things. 

You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor’s “anchoring” cognitive bias at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.

What is Confirmation Bias? Why is it Dangerous for Individual Investors?

26 Wednesday Apr 2017

Posted by wmosconi in active versus passive debate, behavioral finance, confirmation bias, Emotional Intelligence, EQ, finance, finance theory, financial advice, financial markets, Financial Media, Financial News, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, stock market, stocks

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There are many dangers for individual investors to be aware of when investing.  More and more of these dangers and/or complications are being recognized in the field of behavioral finance.  Behavioral finance looks at the psychological and emotional factors that influence the decision-making process of investors.  Oftentimes researchers in this field try to figure out what causes normally rational people to act irrationally.  Unfortunately, it has proven over and over again that, when money is involved, the vast majority of people let their emotions/feelings interfere with their investment decision either slightly or in profound ways.  We do these things without even knowing it which makes it even harder to address and correct.  Keep in mind that Warren Buffett says that having control of one’s emotions is just as important (or even more so) than having a superior intellect that can select excellent, long-term investments.

Confirmation bias belongs in the realm of behavioral finance, but, as many of these issues, it really first has been examined in terms of psychology.  So, what is confirmation bias exactly?  The definition of confirmation bias is “the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses” (Plous, Scott (1993). The Psychology of Judgment and Decision Making. p. 233).  Keeping in mind that confirmation bias applies to many other areas, the primary focus in the remainder of this article will be how it manifests itself in relation to investing.  Now that we have the formal definition, let’s take a look deeper into this very real danger for individual investors.

Individual investors have the natural inclination to make a decision first and then look for information that supports that initial decision.  It also applies at an even higher level than that.  The way that individual investors think they should invest in general is almost predetermined.  The easiest thing to do is to talk to people with the same thought process about investing, search through the same supporting financial media news publications and websites, and listen to the same experts.  Over time, it gets very easy to just keep doing the same thing over and over again.  Plus, it takes an incredible amount of effort to step outside of one’s comfort zone and try to prove that he/she might in fact be incorrect.  Individual investors (and even professional investors, money managers and investment advisors) are not wired to attempt to confirm why they might be wrong.  At first glance, it seems like a totally foreign and nonsensical concept.

So, what are the types of problems that can occur when individual investor does not acknowledge confirmation bias?  There is a long list here are a few to ponder.  First, a big mistake can be thinking that what has happened in the recent past will continue into the future indefinitely.  This danger is especially evident during a bull market.  It can be easy to get carried away and see how much money one made and then keep pouring money in (more than you can really risk).  The converse is true when it comes to a bear market.  After stocks have gone down for a number of months or longer, it is very easy to just give up on investing in the stock market because it seems like things will never turn around.  Second, the danger creeps in when investing by not challenging one’s assumptions.  Even if an individual investor knows at a subconscious level that an incorrect decision was made, there can be a desperate search for any shred of evidence that one can justify nonaction.  Third, there are times when listening to the investment advice of a particular expert can be “addictive”.  By this I mean that it is natural to continue to listen only to the views of that person, especially when he/she made a bold prediction about the stock market that came true.  It can be simple to forget that market timing is extremely difficult and that person could be totally wrong in terms of his/her next prediction.  Lastly, it can feel good to be part of the crowd and not think differently (or at least examine other issues).  There is safety in numbers essentially and, if your investment decision does turn out to be wrong, you can at a minimum take solace in the fact that “everyone else was doing it”.

There are a number of steps that individual investors can take to counteract the dangers of confirmation bias.  First and foremost, the fact that you are aware of the potential trap of confirmation bias is half the battle.  Periodically ask yourself if you have looked for alternative viewpoints and evidence.  Second, you can make a list of why you made a particular investment decision in the first place.  But, more importantly, you should write down what types of events could occur to make you change your mind because your investment thesis was not correct.  It is very powerful to have a written record to start with.  This recommendation actually comes from a reporter at The Wall Street Journal named Jason Zweig.  Mr. Zweig has been writing about the financial markets for decades now and still has a weekly article in the paper (usually in the weekend edition) called The Intelligent Investor.  I really urge you to take a look at this interview with him back in 2009 about confirmation bias.  Here is the link:

http://www.wsj.com/video/when-investing-consider-your-confirmation-bias/B768E62A-AA01-4B37-905F-F3EDA5C72B78.html

Third, you should make it a habit on a regular basis, maybe monthly, to go to various financial market and investing websites that do not mesh with your general investment philosophy.  You can peruse through a few articles that you might find totally different than you interpret a situation.  I urge you to read them with an open mind though and try to be objective.  Lastly, you can bounce an idea off a close friend or advisor and see what they think about your rationale.  It is far easier for them to be objective.  If you do not have anyone to consult with, I would urge you to pose the question in an investing forum.  However, you need to phrase the question in the manner that will address your possible confirmation bias.  It is very common to ask question in a positive manner like “Why should you invest in technology companies?”.  The better way to phrase it at the outset is to use language like “What are some of the reasons why you should not buy gold?”.

Now keep in mind that the advice on confirmation bias also applies to the articles I have posted on my website.  You will note that two of the main themes are using a passive investing approach to invest and striving to keep investment fees as low as possible.  I urge you to go and seek out information about why you may want to choose an active investing strategy as an individual investor.  Look for the reasons why and situations where you might have to pay additional investment fees depending on your particular circumstances.  It is very healthy and beneficial to seek out other information, and I always encourage individual investors to do so.  The one thing that I firmly hold onto is that I would avoid financial websites or sources that say I am right and the other guys are all wrong.  Things are rarely ever so “black and white”, especially in the world of financial markets and investing.

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