Step Out of Your Shadow - Recognizing Investment Bias

Imagine you have spent your entire life chained to a wall in a dark cave. The chains constrain you in such a way that you are unable to turn around to see anything but the cave wall directly in front of you. There is a fire that burns behind you, providing your only source of light. When people, creatures, or objects pass between you and the fire, all you can see are their shadows on the wall. Over time, you recognize certain shapes and associate them with what you think cast the shadows. Eventually, you interpret them into a perception about how the world works.

But what would your view be of “reality” if you were suddenly released from this prison. How strange, or wrong, might the world then appear? This was a question posed long ago by Plato in the Allegory of the Cave. Plato used this story to illustrate how a philosopher, when freed from the shackles of bias, can better understand reality.

In some ways, we are all bound by our bias. Look no further than your social media feeds to see what many of your friends’ “reality” is tied to. These days, it has become almost impossible to keep up with friends’ and relatives’ latest game scores, lost teeth, or birthdays as Facebook has become a forum for sharing “fake” news. Which news is fake? It largely depends on your perception.

If you support immigration reform, you may be more likely to feel emboldened when you see a news story about an undocumented immigrant who has committed a crime. On the other hand, if a news outlet runs a story about how much more expensive some food crops would be if there weren’t migrant laborers, you may stop paying attention or change the channel. This is what is known as confirmation bias, where you have reached a conclusion and then seek out facts that support your belief while ignoring those that don’t.

Investors do this all the time. Many that believe the market is going to fall may give more credence to indicators that fit their bearish narrative. Bulls, however, may cherry pick any good news that bolsters their confidence. The ability to keep an open mind, even to facts that don’t support your world view, can make us better investors and more tolerable “friends”.

Do you feel moved by any of the recent highly publicized and attended protests? Perhaps you were experiencing some herding bias. Investors face similar experiences when there are significant market selloffs, where the tendency is to believe you are the only sucker left that hasn’t sold. Recently, some may be feeling left out as the stock market is hitting new highs seemingly every day.

Following the latest trends, social pressure to conform, or the mistaken belief that a large group must be right are all reasons herd bias happens. Recognizing the tendency to follow the crowd may help you avoid getting trampled.

Excited about making America great again? It’s not unusual to believe we are more likely to be successful (or less likely to fail) than probabilities or ultimate results suggest. For example, a 1977 survey of college professors showed 94% believed their work was above average.[i]  Many other studies have shown similar overconfidence, from college students believing they will outlive their peers[ii], business leaders that their company is more likely to succeed[iii], to people avoiding flu shots due to the belief they are less likely to contract the bug.[iv]

This is known as optimism bias, and similarly, investors suffer from it as well. Overconfidence in dot com stocks in the late 90’s and financials in the mid-2000’s led to two of the worst bear markets in generations. In fact, studies have shown that stock pickers commonly believe their purchases will do better than average.[v] 

Confidence can be a great thing when you are stepping into the batter’s box or going in for a big job interview. Failing to recognize when that optimism has risen to excess can lead to expensive mistakes and failures.

What all of this tells us is that we’re all biased, it’s how we’re wired. By being aware that we are inclined to act in ways that are counter to our intellect, judgment, and even our values, we can come out of the shadows and actually see the light.

[i] Cross, P. (1977). Not can but will college teaching be improved? New Directions for Higher Education

[ii] Weinstein, N.D. (1980). Unrealistic optimism about future life events. Journal of Personality and Social Psychology

[iii] Cooper, A.C., Woo, C.Y., & Dunkelberg, W.C. (1988). Entrepreneurs’ perceived chances for success. Journal of Business Venturing; Larwood, L., & Whittaker, W. (1977). Managerial myopia: Self-serving biases in organizational planning. Journal of Applied Psychology

[iv] Larwood, L. (1978). Swine flu: A field study of self-serving biases. Journal of Applied Social Psychology

[v] Odean, T. (1998). Volume, volatility, price, and profit when all traders are above average. Journal of Finance

Would You Like Insurance? A Look at the Cost of Hedging

Have you ever played blackjack when the dealer flips over an Ace and asks, “Would you like insurance?” It seems like a reasonable wager. The dealer, with an Ace showing, only needs a 10 or a face card to complete an unbeatable hand. By wagering half of the amount of the bet you already have placed, you are assured that if the house hits blackjack, you will at least break even.

But the odds against the dealer hitting blackjack are 9:4. In other words, for each 4 dollars you wager, you should win 9 dollars if the house’s next card is a 10, Jack, Queen, or King. Put another way, the dealer has a 69.23% chance of NOT hitting blackjack and collecting your insurance premium. But remember, the payout is just 2:1. Paying out 2:1 when the odds are 9:4 are a great business model for a casino, but not so much for a bettor, or an investor.

Clients frequently ask about insurance. Life, disability, and long-term care are probably the most common topics of conversation. But when the market is roaring, such as been the case since the end of the Great Recession, an increasingly popular question has centered on methods of insuring, or hedging, against portfolio declines.

There are a couple of ways to approach this topic. One is to look at statistical models to try and understand what the odds of a particular market outcome may be.  I discussed models in last week's Accountable Update. I also found a couple of 2016 articles, one in Forbes magazine and another on the blog Six Figure Investing, that discuss specific statistical models for calculating probabilities of different market outcomes.

For those that find the finer points of statistics more helpful for curing insomnia than finding your next investment, perhaps some real life examples of the cost of insurance will be helpful. We already looked at the raw deal a blackjack player receives at a casino, but another concept that just about anyone with a car probably understands, auto insurance, may provide a better comparison.

I shopped around on the internet and determined that insuring a $30,000 car with a good driving record in Texas will run about $1500 a year with a $500 deductible. While this was by no means a comprehensive study on those rates, it can provide us a guideline for how much insurance costs. In this case, it’s about 5% of the value of the vehicle to cover damages that exceed $500.

One of the most common ways of “insuring” an investment portfolio is to buy a put option. A put option, in simplest terms, is a contract that allows you to buy the right to sell a stock or index at a predetermined (strike) price at some point in the future. In other words, you can “put” it to the person who sold it to you, sort of like you put the body shop bill to the insurance company after a fender bender.

Say you have a $1,000,000 stock portfolio invested in a S&P 500® index fund that you wanted to hedge. The index closed yesterday at 2307.87. Let’s say you are concerned about a greater than 10% drop in market value over the next month or so.  A 10% drop would result in the index dropping to around 2078. Think of the 10% as your deductible, it is the losses in excess of 10% that we are concerned with protecting against. For the purposes of this example, I selected a put option at the 2080 level that expires on March 10.

To hedge a $1,000,000 position, you would first need to determine the number of contracts necessary to insure potential losses. The formula is to take your market value of your portfolio divided by the notional value of the index contract (Strike price x 100). An S&P 500® put option at 2080 x 100 = $208,000. $1,000,000/$208,000 = 4.8, which we’ll round up to 5 contracts.

5 contracts of the SPX 2080 Mar 10 Put would have cost about $1250 each, or $6,250 for the next 28 days of protection. If you repeated that each month over the next year, you would spend approximately $75,000 to insure your portfolio for a drop of more than 10%. In this example, the current cost of insuring your portfolio against greater than a 10% drop is about 7.5% on an annualized basis.

The difference between insuring your car versus your portfolio is that you can’t get around if your car isn’t working. If you aren't planning on touching your portfolio for a while, then you generally can withstand some volatility in exchange for higher expected returns.

On the other hand, if you will need to use your money in the near term, it likely is much less expensive to keep those funds in cash or bonds that are much less volatile. The tradeoff is that they earn less, but the net result is likely to be less expensive than buying protection on a stock portfolio.

This is why we advocate allocating enough of your portfolio to those less volatile assets to allow you to weather the occasional inevitable volatility. A 2.5% return may sound unappealing, until you compare it to the cost of portfolio insurance. Then, it doesn’t sound so bad.

Insurance is a necessary and useful tool to help manage risks in the right circumstances, but casinos and investors typically don't get rich by paying out more than they earn. Keep that in mind the next time you are pondering a hedge to your bets. Even better, get in touch to discuss your situation.