No Easy Roads in Life or Investing - Part 1

No Easy Roads in Life or Investing - Part 1

[caption id="attachment_437" align="alignleft" width="240"]John G. Finley, CFA John G. Finley, CFA[/caption]

I’m a firm believer in taking shortcuts whenever possible. I use them all the time on my computer keyboard and on my Smartphone. While driving, if I can avoid traffic and get home a minute or two sooner, I’ll do it. But sometimes shortcuts don’t work out as planned -- like the year our family took one of those “road trip” vacations out West.

We wanted to see Mt. Rushmore, but didn’t have a lot of daylight left. Squinting at my trusty map (no GPS devices back then), I decided that taking a rural road off the Interstate would get us there faster. Funny thing about maps of mountainous areas: they don’t illustrate all the little curves and dips it takes to get from A to B in just a quarter inch on the state map. It was dark when we eventually got to Mt. Rushmore. Lesson learned.

Oftentimes, shortcuts simply lead to problems

Like finding Mt. Rushmore, oftentimes, searching for shortcuts in life simply leads to problems. Think about raising children. While parenting can be a fulfilling and joyful experience, it can also be just plain exasperating. There’s no such thing as a shortcut to sound parenting. Step-by-step parenting manuals may work with one child. Then baby number two comes along and you’ve thrown the tattered book out of the window. Each child is a unique, one-of-a-kind creation--kids are just too complex for a parenting checklist.

Likewise, investment decisions can’t be reduced to a recipe card. The disinterested “rational investor” who inhabits the pages of textbooks is a myth. It’s like saying that you’re always a “rational” parent-likely fiction as well.

As I’ve written before, human beings encounter all sorts of mental and emotional obstacles and behavioral distortions that keep us from making wise rational investment decisions. Academic researchers call them behavioral biases. Through readings on the subject, I’ve catalogued 56 of them at last count. Evidently, all lessons are not so easily learned.

Behavioral Biases: What they are and what you can learn from them

One category of such biases is called heuristic simplification, meaning that investors often make decisions using simple mental shortcuts, rules of thumb or educated guesses based on their experience or advice of others.

  • One example concerns the legal language found on almost all literature from an investment firm: “Past performance is no guarantee of future results”. The regulators require this language because of something that researchers call extrapolation bias: we think that investments that have done well in the past will continue that good performance unabated into the future.
  • The term local bias refers to another form of behavioral bias. Local bias involves investing in companies we know well and that hold some sort of familiarity or nostalgia for us. In late 2001, many employees of Enron were highly concentrated in the stock of their employers and not only lost much, if not all, of their 401k savings, but lost their jobs as well when Enron filed for bankruptcy.

As I write this, the Presidential Election is upon us and many investors must wonder how the outcome will affect the stock market. People often assume that a Republican Administration will be good for stocks, given the common belief that Republicans are more “pro-business” than Democrats-still another example of a biased assumption. So, one might surmise that a good investment shortcut would involve buying more stocks if Romney gets elected or sell stocks if Obama gets re-elected.

In Part 2, we will look at what investors should be looking at.

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