Confirmation Bias In Investing

One common bias that investors must overcome is known as confirmation bias. It comes into play after we have researched and analyzed a potential investment and made a decision regarding its relative merit. If our impression is that the investment is worthy of purchase and do so, confirmation bias will cause us to only seek out additional information about the investment that confirms our initial positive opinion. Likewise, we will ignore or downplay any new information that contradicts our initial impression. Confirmation bias also works against us when our first research conclusion is negative. If we initially decide not to make a purchase, we will continue to seek out only information that reinforces the original negative assessment. 

Anchoring Bias

Behavioral finance researchers have noted that many of our financial decisions are based on “reference points”. Numerous experiments have been conducted which validate the concept that we make decisions based on a previously identified number. For instance, we may have difficulty deciding if $100 is a fair price for an item #1 if we are initially given no other information. However, if we are shown a similar item and told that its price is $200, we become much more likely to state that the $100 item is fairly priced. This belief occurs even though we have received no additional information about item #1. Surprisingly, this is true even when people know the initial item’s $100 price was merely a random amount.

Investing Trends

Many people claim to understand that successful investing requires a long-term perspective. Yet, they often lose patience when one of their stock market investments underperforms for a year or two, and they abandon it in search of an alternative. As a self-check on your investing time perspective, ask yourself if you would select the man described below to direct your equity investments.

Charitable Gifts

The Covid-19 pandemic has strained the social safety net as job furloughs and unemployment caused many to lose their regular sources of income. As a result, food banks and other charitable organizations have seen huge increases in the number of people relying on their services. Of course, this increased demand puts financial pressures on the charities, but at least one report suggests that donors stepped up their efforts in this time of need.

Fallen Angel Bonds

The title of this posting may conjure up the image of a beleaguered husband prior to an extensive garage sale, but it is actually a valid question when one looks at the current U.S corporate bond market. “Junk” is an investment term that describes high yield corporate bonds issued by financially challenged corporations. Because of the greater risk of missed interest and principal payments by the issuers of this debt, investors demand higher yields. This, of course, costs the borrowing company more money, so these firms struggle with servicing their debt much more than higher quality “investment grade” bond issuers.

Growth Versus Value

There are no laws of science governing investments but there are some frequently observed, on-going tendencies. One of those tendencies is that over many years, growth investing and value investing tend to converge in terms of financial performance with a slight edge noted for value investing. While definitions of each investing style can vary, growth investing usually refers to selecting the subset of available stocks that seem to be growing sales and profits at a rate that is higher than the market as a whole. Often, these are companies that are relatively young and earlier in their life cycles. Conversely, value stocks tend to be older, more mature companies that have well-established market positions and more predictable dividends and cash flows. Since investors seek increasing profit growth, they bid up the prices of growth stocks with the result being higher readings for accounting valuation measures such as price-to-earnings, price-to-sales and price-to-book value. Conversely, value stocks sport lower ratios for such valuation measures and are sometimes termed “bargain basement stocks.” Each style has extended periods when it outperforms but very long-term performance (20-30 years and up) has tended to converge to somewhat similar results for both styles. Since value stock prices are generally less volatile (a measure of risk), their similar returns accompanied with lower risk causes academicians to give them the edge when comparing the “risk-adjusted” performance of these two investing styles.

Defined Contribution Plans

There are numerous academics and economic pundits who have been lamenting the demise of defined benefit (db) retirement plans. Defined benefit plans (most notably, traditional pension plans) have been largely discontinued by private corporations but continue to exist primarily in the taxpayer-supported public sector. The private business entities, needing to maintain their competitiveness to assure their continued survival, have largely replaced their db plans with defined contribution plans (dc) such as 401k’s. The critics of defined contribution plans focus their arguments on the belief that workers cannot build retirement security with dc plans as they will be unable to accumulate large enough account balances. Hence, the naysayers claim that dc plans have been a very poor alternative when compared to the circumstances of retirees from the 1960’s-1980’s. After all, who can argue with “lucrative” lifetime payouts entirely funded by somebody else?

Capital Loss- Turn Lemons into Lemonade

The severe market drop that has arisen from the corona virus induced economic shock has been painful for all investors. It takes a great deal of focus and intestinal fortitude to avoid the temptation to exit the stock market completely. While that’s usually an ill-advised move for long term investors, there are several other actions that investors should seriously consider when confronted by a bear market. Tax loss harvesting is often a worthwhile move as is an in-kind Roth conversion.

Qualified Charitable Distributions

The SECURE Act that was passed in December 2019 has gone into effect and the asymmetry of some of its changes has created a new planning opportunity for IRA owners who have an interest in giving to charities. Prior to this new legislation, IRS regulations mandated that IRA account owners (as well as employer sponsored plans like 401k’s and 403b’s) became subject to the Required Minimum Distribution rules upon attaining the age of 70 ½. The new legislation increased this age to 72. What did not change, however were the rules for Qualified Charitable Distributions which can still be initiated at age 70 ½.

Frequent Trading

Many financial planners discourage frequent trading and attempts by investors to “time” the markets. Their logic is based on numerous studies and research that indicates that individual investors generally damage their long-term financial returns by trading too frequently. DALBAR publishes annual research results that consistently illustrate underperformance on average by individuals relative to general market returns. For example, in 2018, the average individual investor lost 9.42% while the Standard & Poor’s 500 lost only 4.36%. The reason? Too much trading activity and over-reaction to market developments.