From the archives of the blog that was the inspiration for this newsletter...
Some (Useful) Bias Training
"It’s funny what a bull market can do to our brains. . . .
Money earned passively in the market, rather than from toiling at work, can feel easier to gamble with. It is a dangerous bias psychologists call the “house-money effect.”. . .
Everyone wants to assume that they can think rationally. But with bear markets now a fading memory . . . now is an important time to understand the common behavioral biases that cause investors to make regrettable decisions during bull markets.
Here are five others.
The backfire effect. This is a powerful bias that causes us to double down on our beliefs when exposed to opposing viewpoints.
“We think this response occurs because people respond defensively to being told that their side is wrong about a controversial factual issue,” says Brendan Nyhan, an assistant professor of government at Dartmouth College, who has studied the backfire effect in politics.
“In the process of defending that view, they can end up convincing themselves to believe it even more than they otherwise would have if they had not been challenged,” he says.
The same flaw can run wild in investing debates.
If you are convinced that we are in a lasting bull market, how do you feel when you hear someone say that stock valuations are historically high, or that we are overdue for a correction?
If you find yourself so critical of opposing views that you become even more convinced the bull market will last, watch out. Once your priorities shift from determining the truth to blindly defending your original views, you have lost the ability to think rationally.
Confirmation bias. This flaw causes us to seek out only information that confirms what we already believe.
Access to financial opinions has exploded in recent years . . . . But it can be dangerous, because no matter what you believe—and no matter how wrong those beliefs may be—you can likely find dozens of investors who agree with you. Having other people confirm your views may cause you to become more convinced that those views are correct.
Charles Darwin had a knack for obsessing over information that disproved his own theories. Investors should try to do the same.
Anchoring bias. This phenomenon causes us to cling to an irrelevant piece of information when estimating how much something is worth.
Your opinion on how much a stock is worth may be anchored to how much you paid for it. If you paid $100 for a share of Apple stock, you are probably more likely to think shares are worth more than $100 than another investor who paid $80 for the stock.
But the market doesn’t know how much either you of you paid for the shares. And it doesn’t care what either of you think is a fair price. Markets will do as they please, regardless of what price you are fixated on.
Recency bias. This one is simple: It is another term for the tendency to use the recent past as a guide to the future.
People like patterns. If stocks have just gone up, the natural tendency is to assume they will keeping going up—at least until they go down, and then we assume they will keep going down....
Markets move in cycles, but people forecast in straight lines. That is recency bias, and it is particularly dangerous after a long bull market.
Blind-spot bias. This—the most dangerous investing bias—is a flaw that causes us to think the biases described above affect other people, but not ourselves."
Summing Up
Individual investing has to be a long term commitment in order to be successful.
Part of successful individual investing includes the ability to understand the role that our emotions and biases tend to play when stock prices decline.
Since we humans tend to react more quickly to negative events than to positive occurrences, we are much more likely to do the exact wrong things at market bottoms and tops. We too often panic and sell when the market is falling rapidly, and then turn right around and buy when stocks are rising.
That's the losing buy high and sell low 'model,' and it's harmful to one's long term financial health and well being.
So becoming better acquainted with our emotional side is perhaps the best thing we need to know about individual investing.
And the second best thing to learn is the power of compounding and the rule of 72 (money doubles each time the number of years multiplied by the percentage annual rate of return equals 72, as in 12 x 6, 9 x 8).
So start early, stay the course, and reap the long term benefits of a rising stock market.
Thing Two
Long Term Or Bust
We'd like to expand on one of the four ideas we discussed a few weeks ago concerning things a "good" long term investor should internalize. If you'll recall, we said:
"There is no strategy that outperforms all the time. Whatever our benchmark is, there will be periods of time where we are underperforming relative to it. But, If we’re investing in well-run companies, the likelihood is that over time our investment returns will be positive. Day to day fluctuations or short-term periods of underperformance should not cause us undue angst or overreactions (like selling). That is not to say all news should be ignored but rather that it should all be put on the proper time scale."
With that idea in mind, consider the dividend growth investing strategy, which entails buying shares in companies with a record of paying regular and increasing dividends. A dividend growth investor will focus on:
· Companies with a history of consistent dividend yield growth.
· Diversification in companies in a variety of industries, limiting the effect of a decline in one sector.
· Buying and holding because reinvesting dividends is meant to compound returns over time.
· Companies whose dividend yield growth is greater than, or at least equal to, the rate of inflation.
· Companies that “earn” their dividend and make payouts from current profits, not accumulated capital or debt.
And although there are no guarantees in investing, over long periods of time, the dividend growth strategy tends to work out very well for individual investors. Assuming they've invested in fundamentally solid companies, they will likely enjoy the one-two punch benefit of a compounding dividend and a slowly, but steadily increasing stock price. As an example, "dividend aristocrat", JM Smucker (SJM), which currently yields around 3%, has grown its dividend every year since 1998 and has a 20-year dividend CAGR (compound annual growth rate) of 9%. Its stock price has compounded at around 8% over the last 20 years as well. So, an investor would have had a total average annualized return of around 9%. Furthermore, using its dividend history as a basis, it could yield 6% on cost eight years from now. Not bad, huh? BUT there are periods of time where the results can be discouraging. SJM's stock price is down 9% YTD in an up market as investors have bid up growth stocks and have also moved cash out of dividend yielders and into high yielding money market funds.
One that note, see the chart below from a week or so ago that details the YTD average returns for the top 101 stocks that don't pay a dividend (typically growth stocks), the 100 highest dividend yielding stocks (typical targets for dividend growth investors), and the S&P 500. The dividend growth investor, as represented by the top 100 highest yielding, has been crushed. His total YTD average return is negative 3.5% while the non-dividend investor has seen a return this year of 20.43%.
It's hard, if not impossible, to feel good during these times if you're a dividend growth investor who owns stocks like SJM. That's why it's important keep in mind you're investing for the long term (remember SJM's 20-yr average annualized return of 9%). That knowledge will hopefully help you resist the urge to focus too much on (unrealized) short term losses.
Thing Three
Just A Thought
“Better to know a few things which are good and necessary than many things which are useless and mediocre.” — Leo Tolstoy
