When Emotions Get the "Worst" of Us

Dan Ariely is the James B. Duke Professor of Behavioral Economics at Duke University and author of the New York Times bestseller Predictably Irrational. And to my delight, one fortunate night last year, he was a friend who just happened to stop by my house for dinner. We sat around the dining room table with my wife, our son Justin, his wife and their one-year old daughter. We talked about, among other things, the irrationality of stock prices, the packaging of laundry detergent, and the sleep schedules of toddlers. Take solace that Ariely, a highly intelligent professor and author with doctorates in marketing and psychology, could figure out complex problems involving emotions and economics, but was still trying to get a toddler to sleep through the night.

Ariely and I met at a lecture two years ago. I was intrigued by the focus of his studies: how people behave in the marketplace compared with how they would behave if they were completely rational. His interests span a range of ordinary behaviors: buying, saving, ordering food in restaurants, pain management, procrastination, dishonesty – all under different emotional states.

In a recent Harvard Business Review, Ariely explained how he and research partner Eduardo Andrade set out to prove how one’s past emotional decisions can negatively influence future decisions. Participants were divided into two groups: Group A saw a five minute segment from the movie Life as a House, a clip known to irritate and annoy its viewers. Group B watched a five minute segment of the popular TV show, Friends, known to evoke happy feelings. After that, they played the Ultimatum Game in which the “sender” (Ariely) has $20, and offers the “receiver” (the movie watcher) a portion of that money. Sometimes the offer was fair (you get half and I’ll get half) and other times it wasn’t (you get $5 and I’ll get $15). If the receiver rejected the offer, both sides got absolutely nothing. To make a long story short, the agitated group rejected more offers than the happy group. Even though it was highly irrational behavior, the agitated participants preferred to lose free money in order to punish Ariely for making an “unfair” offer.

Now the really interesting part: after Ariely and Andrade gave the receivers time for their emotions to settle down, they played the game again. The previously annoyed group, now no longer irritated, still rejected far more offers than the happy group, who was now no longer glowing from watching Friends. Why? Because the members of each group had tapped the “memory” of decisions they made earlier, without any regard to whether they were under the influence of being annoyed.

All too often, we see aggravated emotions creep into markets like a fog, turning seemingly easy decisions into difficult ones. If that weren’t enough, we see that the lasting effects continue to obscure the judgments of many, even when the aggravation is long gone. A few years ago, investment banks became frustrated by the low returns offered in the market. So they invented financial products and increased their leverage, sometimes loaning out their capital 30 times over. In effect, these banks were fearfully wrapped up in the potential for lost future profits and made the irrational choice. Sadly, this “experiment” didn’t carry the warning “Don’t Try This At Home!” Homeowners became increasingly irritated by their neighbors, brothers-in-law, and people from TV shows like “Flip That House” making loads of money. That aggravation propelled them to put on the blinders, assume home prices would rise forever, lie about their income, borrow more than they could ever afford, and put themselves squarely in harm’s way.

Likewise, at the end of 2008, Joe and Jane Investor were staggering under the weight of their irritated and annoyed emotions. Every time they opened their statements or turned on the TV, they saw a smaller “number” than the day before. It was hard to see the rational point of view: that the world wasn’t going to end, that P/E multiples were historically low, that stocks were extremely underpriced and that US Treasuries were fairly overpriced. Just like in Ariely’s experiment, investors seemed to be offered $5, free and clear, but turned it down because of emotions rather than rationality.

The irrational behavior continued into 2009 and by all measures appears to still be present today. The Vanguard Group reported that January 2010 was the first month since January 2009 that more money flowed into their stock funds than their bond funds. And according to the Investment Company Institute, it seems that most of the rally was the result of mutual fund managers putting their large cash reserves to work, rather than new investors entering the market. Meaning, when stocks were cheap, investors plowed money into bonds, but once stocks got more expensive, investors decide to buy again. It’s not surprising that Joe and Jane are once again aggravated. They have missed most of the rally and seem willing to buy any stocks, regardless of the business quality or dividend yield.

So, how do Joe and Jane avoid making irrational decisions? Let’s go back to Ariely’s study. Imagine if the aggravated subjects were allowed to consult their most trusted advisor and even let that person make the decision for them. It doesn’t matter if the advisor was their pastor, hairdresser or bartender, as long as they were very rational (i.e. they weren’t affected by the aggravating movie clip), highly qualified (i.e. they knew that $5 was better than $0) and held to a fiduciary responsibility (i.e. they were solely devoted to making sure the subject made the right choice). I can almost guarantee than the instances of irrational behavior would plummet, hopefully to zero. In essence, that’s our job. Our mandate is to think and act as that most trusted advisor for our clients – giving rational, qualified, fiduciary advice and direction.

Then how is Jonathan Smith & Company making rational decisions in this market? As we’ve mentioned in recent commentaries, investing rationally today involves: buying high-quality stocks with correspondingly high-quality dividend focuses, owning corporate and high-yield bonds with less inflation risk than treasuries, and aligning our clients’ overall expected risk and return with their respective stomachs and wallets. Perhaps the most meaningful way we’re making rational decisions is by knowing our clients well and helping them navigate their financial lives in a personalized way. We ask everything from “what will you regret on your deathbed?” to “what’s your credit card debt and interest rate?” We inquire about their history of investing and the things that keep them up at night. And we try to impart our experience and knowledge by addressing issues from “how commodities act as a diversifier” to “how to pass on financial wisdom to your kids.”

And if that doesn’t work, we always have a DVD queued to a clip of Friends. For some reason, that usually seems to put everyone in a good mood.

Warren Buffett Op-Ed: Buy American. I Am.

Justin here.

Warren Buffett wrote a great Op-Ed piece for the New York Times this morning. Well worth your next five minutes.

Buy American. I Am.

By WARREN E. BUFFETT

Omaha

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

The Decabox

Justin here.

We don't call market bottoms. It really isn't in our skill set and we wouldn't know where to start. We try to stick to buying cheap companies that we think will get less cheap.

But . . . if I was required by law to call the bottom, it would be when CNBC unveiled the decabox (left).

10 talking heads + 2 anchors + 3 scrolling tickers + 1 "is your money safe" logo = possible market bottom.

It looks like they unveiled it October 10th, see if you can find that day on this chart. But remember, we don't call market bottoms . . . unless required by law.

Days till we reach zero

On more down days than I'd like to admit, my team mates have heard me say, "At this rate, we'll be down to zero in no time."  Now they've started saying it before I can get the very words out of my mouth.  It's "tap code" at JSCO for a bit of gallows humor that our team uses to puts things back in perspective, to put the train back on the track, to put the cart behind the horse.  You get the point.  As any fool who can push a stick in the dirt can tell you, it's not going to go to zero, even though we sometimes think it will.

Stock markets are behaving as if all the indexes will go to zero in less than a month, maybe sooner. No one knows the future, but I for one have a hard time believing that this very real, very serious financial crisis will play out by going to zero. The Dow Jones Industrial Average, a proxy for the market, has in fact experienced record of volatility and panic selling this high only three times since December 31, 1946, the end of World War II:

• October 16, 2002, when the Dow Jones was 8,036.03
• November 9, 1987, when the Dow Jones was 1,900.20
• November 5, 1974, when the Dow Jones was 674.75

The summers of 1962, when the Dow Jones was 572, and 1970, when the Dow Jones was 874, experienced high but slightly lesser volatility and panic selling.   The chart below shows the Dow Jones Industrials and our fear and volatility indexes from December 31, 1946 to the present.  Click the chart to full size. 

No one knows where and when all this panic will land.  Some wonder if it ever will.  It will.  History records that extreme volatility and panic selling do not last indefinately.  At some point, the invisible hand of Adam Smith kicks in and eliminates whatever shortage exists.  Some would say his invisible hand has already been working off the shortage of buyers.  Extreme volatility and panic selling provide wonderful opportunities to buy shares of excellent businesses at bargain prices.  Today's headlines are rarely the same as what history's judgement is going to be. 

If you haven't already seen it, study the wonderfully perceptive presentation by Weston Wellington of Dimensional Fund Advisors that Justin described in his post of October 2, part of which is below:

• "Earlier this week, I came across a presentation by Weston Wellington with Dimensional Fund Advisors, called "Is It Different This Time?" Wellington reviews our nation's past and, in particular, the media's reaction during those time. He does a great job of bringing some perspective to a volatile time.  (Justin said viewing it was guaranteed to lower blood pressure 20 points for every viewing.  If current levels of volatility and panic don't ease up soon, I'll need to view it several times a day.  I guess there could be lot worse things than reinforcing one's long-term perspective. 

This is not a recommendation to buy or sell any security, market, or an endorsement of any investment philosophy, firm, or process.  This is just a call to sit down, take a breath, and study history.

If we did more of the latter, I think we could get out of this

Friday morning's broadcast about the Wachovia Takeover included two pearls of wisdom; I heard them as the interview ended and think it's safe to assume Marketplace listeners (and Renita Jablonski) might not have heard them.  The interview is only 3 minutes long and well worth hearing/reading.  Click the player's "play" button to play; hit "pause" button at 3:03 marker to stop. 

Bonus: Chris Whalen notices tremendous people at Wachovia.

TEXT OF INTERVIEW

Renita Jablonski: Wells Fargo is buying Wachovia for just over $15 billion. That takes Citigroup and the Federal Deposit Insurance Corporation out of the picture. Citi was only looking to grab Wachovia's banking operations. The FDIC said it would step in to pick up any loan losses. Wells Fargo says this morning it will acquire all of Wachovia and that it doesn't need the government's help.

We're joined now by Chris Whalen, managing director of Institutional Risk Analytics. Chris, you've been watching these developments for awhile. What do you think of Wachovia now getting together with Wells?

Chris Whalen: I think they're a much better fit for one another. I also was really a little concerned about Citi, because you know, they have the most subprime consumer focus in their business model -- Citi's loss rate on loans, for example, tends to be twice the other large bank peers'. So I am not keen on seeing Citi buy anything right now.

Jablonski: And we should mention that Wells Fargo did play a little game of hard to get here because it had initially wooed Wachovia with a $20 billion figure, kind of pulled out of that -- that's when the Citigroup / FDIC thing started and then came back. What brought Wells back to this?

Whalen: Well I think the Wells Fargo folks ran the numbers and they decided that they needed to make a bid. If you look at Wells Fargo's perspective, they have a way of getting into the northeast, into the southeast, and that's a beautiful thing for them, cause they're now a national franchise. And once they deal with the asset quality problems, they have tremendous people at Wachovia that they can integrate into the Wells Fargo. And I think they couldn't say no -- they had to get in the game. And that's great news for all of us.

Jablonski: How important is the timing of this deal, coming down on this day of the House bailout vote? I guess this raises the question, is government intervention truly necessary right now?

Whalen: Well, not this intervention. I've been opposed to the House plan since day one, and the reason is we're fighting a battle that we should have fought six months ago in terms of liquidity, the accounting rules that started this mess. And really, the big picture here is we're going through a deflation. We're having asset values fall, a lack of a bid for many assets. We have to fix that and make leverage our friend again.

Jablonski: But I have to ask you this, I mean it seems the perception at least is that Wall Street is so much counting on this bailout at this point.

Whalen: Well, don't worry about Wall Street. Believe me, Wall Street will be there tomorrow. But we've got to stop looking at short-term market indicators as an indication of reality. I think we spend far too much time looking at the television set and far too little time talking to one another. And if we did more of the latter, I think we could get out of this.

Jablonski: Well, it was good talking to you. [read: Me give up watching TV network news and opinion shows?  No way.]

Whalen: Thank you.

Jablonski: Chris Whalen of Institutional Risk Analytics.

The Doctor is In

Ron Lieber knows value when he sees it.  Not intrinsic value, but examination value.  In his feature article in today's New York Times, he says good financial advisors have the examination skills of an ace psychologist.  I've heard financial advisors called lots of things, but I haven't often heard them called keen observers of minds and money.  Lieber rounded up a bunch of planners and advisors who got their starts as psychologists or studied the field as graduate students. 

Lest you think I fall into either of those categories let me assure you neither I nor anyone else in my firm started as a psychologist nor studied psychology in graduate school.  We have, however, spent hundreds of hours with psychologists, some spent on their couches trying to understand our own quirks and biases, but hundreds more spent with clients, psychologists, and psychiastrists on our couches, though fortunately not all at the same time.  Meir Statman taught us how to "make science our ally".  From Dan Ariely, we've discovered how hidden forces direct our minds in the making of decisions that are predictably irrational.  CFA Institute provides us with a digital library filled with presentations on economics, finance, and behavioral psychology, explained by world-class experts in their fields.

We take our calling seriously and have asked more than one client to encounter professional therapy, and our reading room has served as a makeshift emergency room for more than one financial intervention, the most memorable of which included: the client couple, her therapist, his therapist, their accountant, our management team, and their small group.  (I'm just glad the fire department didn't pop in that day, checking expiration dates on fire extinguishers and rounding up frayed extension cords, if they had, they would have had to join up with our recovery group (hey what's a few more people?), never mind leaving a fire truck parked on the curb with its flashers on.  We look back on that day with fondness and gratitude; each participant shone, contributed magnificently, and on that day, the hero (the husband) and the heroine (the wife) put a stake in the ground, changed the river course for good, and re-wrote the history books of their lives.    

Lieber's feature is worth the read.  He shows real advisors in a light neither the newspapers nor the talking heads know anything about, maybe because it doesn't sell advertisements.  Growing money is a process that doesn't happen overnight, it takes years and decades, not days.  Check the article out here.

Most of you reading this post can take comfort in the reality that time on your side is the best insurance policy against volatility and permanent loss of capital. Some of you can't, maybe time isn't on you side.  No psychology sheepskins here, just authentic, wise, and caring people, alumni of the bear markets, the emergency room, and the trenches of real life.

If anybody knows of any other articles about financial advisors serving as financial therapists, please leave leave a comment or drop us a line. 

Enemies in the financial markets are fierce warriors

Jonathan here. Having just talked with his friend in Manhattan, Dick Barron, business reporter at the Greensboro-News Record, writes, in his BizBytes newsletter (click here, follow instructions to subscribe to BizBytes)

• "As one of my friends in Manhattan wrote today on [his] Twitter [page]: "Just walked to Wall Street for a meeting and back. The mood on the street is weird. Everyone looks weak, frightened and angry, like on 9/11" [emphasis mine].

Sun Tzu wrote The Art of War in the 6th century BC. His military strategies are still being taught.

• “Draw them in with the prospect of gain. Take them by confusion. Use anger to throw them into disarray."

Understanding Sun Tzu's brilliant strategies puts the unprecedented economic events and (investors' unprecedented reactions) into perspective.

• Investors have been drawn in with the prospect of gain.
• Investors have been taken by confusion.
• Investors have been thrown into disarray.

You need allies in your war. When the News-Record called us during Monday's 504 point drop in the Dow, we said investors needed to "take a deep breath," and we explained why we didn't need to "stay glued to the TV for the latest headline." Click here to read the article.

Fighting ShortTermism

Here's a great little piece from the WSJ today, Don't Give Up on That Fund - Not Yet.

. . . the study, conducted by Baird Advisory Services Research, looked at more than 1,300 funds, defining "high performers" as those that topped their benchmark by one percentage point annually over the 10 years ended in 2007. About 505 funds qualified.

The key finding was that many of these top funds went through periods where they got killed by the market or their peer group. More than three-quarters of these high achievers had at least one three-year stretch where the fund lagged behind its benchmark by one percentage point or more. More than half of the funds experienced benchmark underperformance of three percentage points or more, and nearly one-third of them lagged behind by five percentage points or more in a three-year period.

Despite those bouts of underperformance, the funds were able to be superior achievers over the full 10-year window.

Tim Byrne, director of Baird's Private Wealth Management Research, Products and Services, said the moral of the study is that even the best money managers have periods where they don't look so good, but the longer an investor sticks with them the better the chances for success, for high performance over time.

"The problem is that people buy a fund after the manager has proven that they are a high performer, but they sell the first time there's a problem," Mr. Byrne said. "They wind up chasing performance -- buying high and selling low -- instead of sticking with a manager who has proven that they can deliver if you give them enough time."

Short-termism

The chart (click to enlarge) shows annual turnover rate (churn rate) for shares of NYSE listed companies. The black axis (Y1) shows annual turnover increasing dramatically from 10 to 30 percent during 1940 to 1980. During 1998 to 2008, turnover increased from 76 to 139 percent. Time held (years) is shown on the red axis (Y2); each NYSE share was "held" continuously by an investor four to eight years, presumably before it was sold, during 1940 to 1980. In the last ten years, this "holding period" has been punctuated from sixteen months to down to less than 9 months.

• Such a churn rate imparts higher transaction costs to investors; with greater trading also comes the risk of making greater mistakes.
• An investment requiring 2 - 3 years time for the market to recognize potential increases in intrinsic value faces unprecedented opposition, in an environment that typically keeps its shares less than nine months before selling to buy another.
• Corporate managements, under ever increasing pressure from stockholders, financial analysts, global competitors, and takeover groups sacrifice long-term strategic vision in the pursuit of beating "next quarter's earnings guidance."
• In contrast, a group of Fortune most admired corporations for "long-term investment" had an average turnover rate of close to 60 percent in 2005.
  

Short-termism destroys wealth. CFA® Institute occupies the forefront in a vital challenge to raise awareness and to challenge the wide range of short-termism's stakeholders to exercise leadership in the effort to win a war against the unnecessary destruction of capital. CFA® Institute's excellent resources may be accessed here.

source: NYSE Factbook, Forbes, CFA® Institute, Jonathan Smith & Co.