Who, Me?  Biased? 

It’s probably politically incorrect to admit this, but I can be a little prejudiced.  We all have our biases, and some of them are healthy and some not.  Keeping these predispositions from getting the best of us and blinding us to reality is a common problem we all deal with from time to time.

We humans tend to invest when we are predisposed to think the market will go up.  But when our biases are not born out by market action, it is foolish, and expensive, to stick with them.  Yet sadly many folks do stick with losing investments because they believe that if it went up once it will go up again or because so-and-so said it would go up it just has to go up some time. There are so many variables to consider that the financial markets are truly unknowable in their entirety.  The weather, crack pots a half a world away, a kid in a garage developing new technology - there is simply too much to figure into the equation.  Even full time professional portfolio managers like myself are limited to dealing with probabilities and making educated guesses.  We never really know for sure.

In fact, if anyone tells you that they know for sure, keep your hand on your wallet and back slowly away.  There are no slam dunks in this business.  No guarantees.  We can never be certain about anything because investing involves too many unknowns. Biases tend to make us think we know what is going to happen whether the bias is positive or negative.  When we are right our biases can keep us out of a lot of trouble and make us a lot of money.  That we never really know for sure does not mean that we are never right.  Our biases are often right.  The trouble comes when the biases are proving to not be right and we refuse to give them up.

In the 1990’s the markets went up with few pauses.  Buying and holding was a common bias that investors developed during this period.  The evidence was everywhere that you could do very well by just buying an index fund and holding it.   Down markets were all short and swift, and then the advancing market continued on.   It was a simple, cheap, effective strategy.  What is there not to like about that?

The conditions in the 1990’s were clearly right for buy and hold and many investors thought they had the investing game all figured out.  They were certain they knew what worked because their experience confirmed it.  Their bias became a conviction.
But conditions changed in 2000.  Unfortunately many investors and sadly many financial advisors refused to change their biases in light of the new market conditions.  They were convinced they would be proven right in the long run.  Their experience, bolstered by Wall Street’s exhortations to “stay the course”, reinforced this conviction.

Michael Price, publisher of Investor’s OnTrack and a brilliant hedge fund manager, taught me that the success of most strategies is determined by the long-term trend and when that changes strategies will begin to fail if not changed.   Sir John Templeton, founder of the Templeton family of mutual funds often said “All things cycle in and out of favor.  Investments and investment styles.”
Because of these ideas, I was prepared to change the investments my clients held as the markets began to change in 2000.

Buyers of S&P 500 index funds are still waiting to recover from the losses incurred since 2000.  Six years later, the S&P 500 Index is still 15% below it’s 2000 high.  Holders of Nasdaq index funds may never see account values back to the 2000 levels during their lifetimes, their losses were so great.  What happened?

Those investors clung to their biases despite the markets shouting, “no, No, NO!” and providing day after day’s worth of data to prove how wrong these investors were.  One of the hardest things to do in life is to let go of a bias, but to be a successful investor one must be willing to let go when a bias stops working on your behalf.

When the markets or the world in general gives us information that conflicts with our preconceived notion of things it often means that there is something bigger going on that we cannot yet see or understand.   But not seeing it does not mean it is not there.  Remember, the market reflects all information that is knowable.  When market action is in conflict with our preconceived notions of what ought to be happening, the part that we don’t know about is in our face.

When the market numbers tell us that things don’t fit our ideas of what should be happening, we can recognize reality and back away from our biases, or we can choose to continue to beat our heads against the brick wall of the financial markets.

Here at the firm, we deal with this common investment problem with a systematic approach to investing.  One technique built into our systems is called “stops”.  When we buy an investment we pick a point at which, if the investment moves against us, we are willing to admit we might be wrong and there is more going on than meets the eye.  When we hit a stop we sell.
Managing investments often involves a larger than normal ego.  Even the geeks, quants and gearheads I rub shoulders with at conferences for investment managers all have good sized egos.  Few rocket scientists (and some of my colleagues are literally former rocket scientists) get that far without realizing they are pretty bright.  And they wouldn’t be managing millions or billions without being right more than they are wrong.

But even these brainiacs have to be willing to recognize the message in the numbers that they might be wrong this time, and back away from an investment.

Brokers, those who just sell investments, but don’t really manage them on a daily basis have a particularly tough time with this issue.  Investments with big commissions are often justified as being intended “for the long haul” to minimize the commission expense by spreading it out over many years.  So, the ego involvement on the broker’s part to not change an earlier recommendation can be particularly strong.  Fee based managers don’t have this commission trap to overcome.  And, if they are true money managers, watching each investment they deal with every day, they also have a better chance of seeing a change in the market when it is happening.
Being successful at managing investments demands discipline.  The need to overcome one’s biases when they are no longer being useful is part of the human condition.  Whether you use stops or other methods of discipline is immaterial, but a method must be found or the price can be significant as index buy and hold investors have found out.