As 2020 begins, the year may change, but human nature does not. Humans evolve and refine their thinking, yet common cognitive biases remain. This is especially true when markets are near lows or, as the new decade begins, near highs. We believe enhancing awareness of these biases can improve long-term portfolio performance. So let’s take a quick journey inside the brain, consider how biases impact investors, and how OPCM attempts to mitigate their impact.
Fear of Missing Out
A phenomenon that is common near market highs is the fear of missing out (FOMO). The amygdala, a key part of the brain that handles emotional processing, is helpful in identifying if there is a threat to survival. Often the amygdala serves its purpose well. But in investing, the amygdala can make investors see others succeeding, feel like they are missing out, and want to join the crowd. From a historical standpoint this makes sense. Survival was enhanced in a pack. If others were gaining more resources, their relative chance of survival was enhanced and yours diminished. But in investing, FOMO-driven chasing of short-term results can threaten long-term returns.
Recent market history is littered with examples of assets experiencing remarkable returns, thus driving FOMO, before declining. Late 2017 had the cryptocurrency exuberance, before assets like bitcoin went from $20,000 to less than $4,000. Late 2018 had high interest in marijuana stocks, before most marijuana stocks lost more than half their value. And 2019 brought the most recent example – a wave of highly touted initial public offerings (IPOs). Published on June 28, a CNBC headline exclaimed “IPOs have their best quarter in years in terms of performance and capital raised.” The dollar value of 2019 domestic IPOs was the most since 2014. There was an intense desire to buy private companies with billion-dollar-plus valuations, labeled “unicorns”, that were going public. FOMO’s harmful symptoms – ignoring fundamentals and valuations, while chasing short-term performance – led to unpleasant results. Consider the basket below of some of the most well-known 2019 IPOs:
IPOs, marijuana stocks, and cryptocurrency may get dismissed as niche bubbles that were easy to avoid. But FOMO can arise in any individual asset or asset class where strong performance has occurred. FOMO is tough to fight because it is fed by multiple cognitive biases. Many of these biases fall under two categories – short-termism and inertia.
A few common biases include hyperbolic discounting, where small payoffs quickly received are preferred vs larger payoffs accrued over the longer term; recency bias, where people put a disproportionate weight on recent events and extrapolate them into the future; and risk compensation, where people want to take bigger risks when safety is believed to have increased. An asset’s strong recent performance can lead to people heavily weighing that experience, extrapolating it, making them feel more safe and thus more willing to take risks, and therefore settle for small, near term payoffs while ignoring the risk of lower longer term returns. Taken together, these short-term biases help fuel FOMO.
When times are good for the broad market or a specific asset it is hard to reassess investments that have worked. Inertia sets in. Status quo bias is the preference to maintain the present setup over changing. Endowment bias irrationally overvalues what is already owned, creating an aversion to divest it. Confirmation bias leads to focusing only on data that supports currently held beliefs. The ostrich effect leads to ignoring negative data. All four biases contribute to making it difficult to exit an asset that has performed well. Inertia, combined with short-term biases, help drive FOMO. To combat the factors that drive FOMO, an antidote is needed.
No investor is immune to FOMO. To think otherwise is blind spot bias, where one identifies biases in others but not in oneself. A disciplined investment process, however, can act as an antidote to FOMO, mitigating its impact on investors.
Key process steps include, but are not limited to:
1) Rebalancing by trimming popular asset classes that are overweight vs their target range and increasing unpopular asset classes that are underweight
2) Reassessing and challenging the thesis behind existing portfolio positions and market views, while possessing an adaptability and willingness to adjust as facts change
3) Maintaining discipline around buy and sell target ranges on prospective and existing portfolio positions, even if, in an effort to maximize longer term payoffs, that leads to cash balances increasing
4) Building out new accounts patiently when market froth exists
In the short-term, these steps often lead to questions like: Why was this recent outperformer trimmed or eliminated from the portfolio, while a recent underperformer was increased? Why isn’t cash closer to zero? Why reverse course and change a view on an asset or asset class? Why bother owning Asset X? Why not own more of Asset Y? In summary, the action is a result of a process meant to help OPCM act in 2020 and beyond as a fiduciary to mitigate cognitive biases and improve long-term results for clients.