academics, anchoring, behavioral economics, behavioral finance, Ben Graham, Bill Ruane, Capital Asset Pricing Model, CAPM, Charlie Munger, cognitive bias, Common Stocks and Uncommon Profits, David Dodd, economics, economy, Efficient Market Hypothesis, EMT, finance, invest, investing, investments, mathematics, Modern Portfolio Theory, MPT, performance, Phil Fisher, portfolio, portfolio management, Security Analysis, stocks, uncertainty, Warren Buffett
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 friends’ attention, you can ask them what the return of the DJIA was for 1987 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 to 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.