Why New Year’s resolutions often fail: A guest post by Kees Koedijk and Alfred Slager

Thanks to Kees Koedijk and Alfred Slager for this guest post. Visit their blog here.

Top 10 stocks and funds to invest in for 2011 circulate widely. It’s a recurring theme with a predictable storyline at the end of the year. The analyst: “Well, we indicated that stock XYZ should be the best performing one this year, and it should have been the case, but it has not for good reasons.” Analysts then borrow the “deus ex machina”  plot device from the theatre (literally, “God out of the machine”), in which  a seemingly inextricable problem is suddenly and abruptly solved with the unexpected intervention of some new character. For analysts this usually boils down to central banks not behaving like they should, politicians meddling with economics or misplaced optimism or pessimism of consumers or companies.

So unless the investing public suffers from collective amnesia with a yearly cycle, the real merit of predicting is not the prediction itself. Maybe it’s a form of mating game in the investment industry. The analyst, bank or mutual fund signals with his prediction to the investor that he knows the intricate details of financial markets, and is therefore fully in control of the risks attached to an investment. And once you’re in control of the risks, then there is actually no risk attached, is there? An elegant way to play into investor’s permanent desire for free investment lunches, an important theme in Meir Statman’s insightful book “What Investors Really Want”.

Maybe institutional investors and pension trustees should be given a second chance for better New Year’s resolutions. If they’re smart, they won’t focus on predictions, but on understanding why predictions continually fail, and how to benefit from this insight. This requires delving more into the beliefs behind the economic theories, and how they affect your investment decisions, the central theme of our recently published book Investment Beliefs. A Positive Approach to Institutional Investing. The problem at hand is quite simple. Despite all the research done and money spent in the financial industry, diverging views persist in economics and finance. A solid theory, broad dataset and sound research methods should be able to resolve ongoing debates and lead to accurate predictions. Economists and researchers surely put an enormous effort into research, but resolving debates tends to move slowly. Economics and finance are tough subjects to investigate. Why is this?

A historic perspective comes in handy. Investing theory and practice have developed dramatically over the past five decades, yet as Andrew Lo argues, there still is no objective framework around for viewing capital markets and deciding how to apply these insights for investment purposes. Active management, passive management, absolute return strategies – all are different views of capital markets that happily co-exist. Yet none can be pinpointed as the right one. Theories in investments and finance simply do not have the same degree of confidence as theories in physical sciences. The main theories have not been road tested; basic premises are not conclusive. For example, is there any agreement on whether financial market pricing is efficient; the basis for passive management? Research findings are inconclusive. There is an increasing amount of evidence on “anomalies”, unexplained gaps between predictions and realizations. However, no workable alternative for the underlying theory has been formulated that can be put to good use on a large scale. Moreover, few investors are actually able to exploit these “anomalies” and turn them into higher returns.

So in the meantime, students and investment managers learn that efficient pricing exists, but observe and act otherwise in practice. Believers in inefficient markets usually invest in what they perceive as undervalued stocks, sectors or assets, and do appreciate market-timing. In a brilliant stroke of marketing, they have labeled themselves as “active” managers, ideally positioned for investors who want to be in control and want to win. Believers in efficient markets on the other hand focus on buying the index against the lowest costs possible: costs are after all a certain drag on your returns, while the free investment lunches pictured by the active managers have yet to materialize.

This discussion suggests that the smart, rational money is on passive investing. The reality is the other way around. The overwhelming share of equities is invested by active managers. Our experience is however that pension funds would make fundamentally different choices if they were aware of the uncertainties behind the economic and finance theories – after all, it boils down to what you believe in. We call this investment beliefs: an explicit view on how to interpret, and approach a debate in the financial markets. We covered active versus passive management as a noteworthy investment belief, but there are many other beliefs out there: on sustainability, risk premium, investment horizon, risk management- to name a few.

Investors simply have to deal with the fact that many debates never really reach a firm conclusion and keep haunting them. Proponents of active management have just as much ammunition in the form of anecdotal evidence or research to prove their case to sympathizers of passive management as the other way round. There is no single objective truth in the financial markets, just an accumulation of learning by doing and adapting to new realities. Investment beliefs address this uncertainty and make it manageable – not predictable.

So, chances are that the predictions will once again miss the mark. This shouldn’t worry investors, and certainly not prevent us from filling out the sweepstakes. The process of arriving at a prediction might well be more important than the prediction itself. Wouldn’t that be a great way to actually realize a New Year’s resolution?

What’s next in 2011?

Are you wondering what’s next in 2011? McGraw-Hill Professional the publisher of my book What Investors Really Want asked a few of their authors (including me) what we think the New Year will bring. They then collected these ideas and predictions into a thought-leadership e-Book, aptly titled What’s Next 2011 that covers the business outlook in a range of areas including Marketing, Sales, Finance, Leadership and Innovation.  If you would like to download the e-book I invite you to go here.

Blog Tour

Thanks to all those who agreed to host me on my blog tour!

• Susan B. Weiner’s Blog on Investment Writing
• Fisher Financial Strategies
• Canadian Capitalist
• The Rational Walk
• Global Economic Intersection
• Women on the Move
• Money Science
• Independent Investor
• Financial Tales
• Portfolioist
• Canadian Dream: Free at 45
• Canadian Finance Blog
• Gen X Finance
• Investment Beliefs
• Canadian Finance DIY
• Abnormal Returns
  

Behavioral Finance in Social Security

We want freedom from the fear of poverty, yet we also want hope for riches. Government provides the first in Social Security and the second in lotteries. Social Security benefits alleviate some of our fear of poverty, and lottery tickets carry some hope for riches.

The Deficit Panel, chaired by Erskine Bowles and Alan Simpson, made several recommendations for reducing our mushrooming deficits, including revisions of Social Security. The Panel’s recommendations will be hotly debated in the months ahead, and the idea of privatizing Social Security will surely come up. Some will argue, as has been argued before, that Social Security should be structured in the image of IRA or 401(k) accounts, a voluntary program where people can deposit whatever Social Security money they wish during their working years and live on whatever that money yields in their retirement years. They will also argue that people should have the freedom to invest their Social Security money in anything they wish, whether Treasury bonds, stocks, real estate or gold.

Social Security can be structured to alleviate fear of poverty or promote hope for riches, yet it is structured to alleviate fear of poverty. Social Security can be structured as a voluntary program or a mandatory program, yet it is structured as a mandatory program. Social Security can be structured with private accounts or a national account, yet it is structured with a national account. Social Security can let people to choose their investments yet it allows only an annuity with monthly payments terminating when people and their dependents die.

President Franklin D. Roosevelt explained his rationale for Social Security when he introduced it. He said: “We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.”

It is evident from President Roosevelt’s words that Social Security was designed from the outset to alleviate fear of poverty rather than promote hope for riches. It is also evident that it was designed as an insurance program rather than a savings program or pension plan. The rich need little protection against “poverty- ridden old age,” but the poor need it. This implies that Social Security was implicitly designed to “spread the wealth,” where the poor are likely to receive more, relative to their payments, than the rich. Moreover, the structure of Social Security is implicitly designed to counter behavioral deficiencies reflected in cognitive errors and insufficient self control.

Young people with sufficient self control find it easy to buy private insurance similar to that of Social Security at a price which might not exceed the price they now pay for Social Security. But young people with insufficient self control might be tempted to forego such insurance. Moreover, people afflicted by cognitive errors might invest Social Security unwisely. Insufficient self control and cognitive errors might consigns people to poverty-ridden old age
It is good to pause from time to time and reevaluate programs, such as Social Security, set decades ago. The deficit accompanying our crisis compels us into such reevaluation. We should consider the rationale for Social Security and its advantages and drawbacks before we proceed to revise it.

The gold rush of fear

“In anxious times people seek cover in gold,” wrote the New York Times in November 2010, as the price of an ounce of gold crossed the $1,400 bar. “People are coming in to buy 50 or 100 coins at a time, which is hefty for individuals,” said a coin broker. “It’s not just rich people, either. A lot of people are putting 30 to 35 percent of their net worth in gold; they are scared to put money in paper assets. ”

Fear is driving up the price of gold yet there is reason for fear. It was not long ago that we have lost almost half of the value of our stocks, unemployment is still hovering around 10 percent, budget deficits are huge, money is printed in enormous quantities, and currency wars are brewing. Still, even a gold-bull is concerned that the price of gold has shot too high. “It’s beginning to smell a little like the beginning stages of a bubble,” he said.

We are all gripped by fear from time to time, yet fear is not a good investment guide. Few accidents are more horrifying than airplane crashes, yet the fear elicited by such disasters depresses stock beyond reason. Aviation disasters cause actual losses lower than $1 billion on average, but the loss in the value of stocks following an aviation disaster averages more than $60 billion.

We are less willing to take risk when we are frightened than when we are calm. In one experiment, a group of students were offered money to stand before the class the following week and tell a joke. A flat joke can be embarrassing, so it is not surprising that some students who agreed to tell a joke withdrew in fear when the time came to stand and tell a joke. But students who were frightened were more likely to withdraw than students who were not. Half the students in the experiment were shown a fear-inducing film clip from The Shining, Stanley Kubrick’s classic horror film, before deciding whether to tell a joke or withdraw. It turned out that a greater proportion of them withdrew.

Fear misleads us to avoid risk even when it is wise to take risk. Here is an investment game: I’ll toss a coin right before your eyes. If it comes out heads, I’ll pay you $1.50. If it comes out tails, you’ll pay me $1. We’ll play 20 rounds of this game. Before each round you can choose to participate or sit it out. Ready? Suppose that you have lost three dollars in the first three rounds because all three tosses came out tails. Do you choose to participate in the fourth round or do you choose to sit out?

Three losses in a row would arouse fear in normal investors. Many choose to sit out the fourth round. But there is no good reason to be afraid because the game is stacked in favor of those who play all 20 rounds. In each round we have a 50/50 chance to lose $1 or gain $1.50. Our maximum loss is $20 while our maximum gain is $30. And even if we lose, a $20 loss is hardly catastrophic. Yet brain-damaged players were more reasoned at the game than normal players. Undeterred by fear, brain-damaged players played more rounds of the game than normal players and won more money.

There is a lesson here for normal investors. Fear grips us when we watch our portfolios day by day and see so many losing days. Fear grips us even more strongly when we watch losses in our portfolios over many months or even years, as happened in 2008 and early 2009. Fear urges us to sell our stocks and invest the money in gold or put it under a mattress. Our emotional response is normal, but it gets in the way of wise behavior.

References:

• Guy Kaplanski and Haim Levy, “Sentiment and Stock Prices: The Case of Aviation Disasters,” Journal of Financial Economics 95 (2010): 174–201.
• George Loewenstein, Elke Weber, Christopher Hsee, and Edward Welch, “Risk as Feelings,” Psychological Bulletin 127, no. 2 (2001), 267–286.
• Nelson Schwartz and Graham Bowley, “In anxious times, investors seek cover in gold,” New York Times, November 10, 2010, p. A1.
• Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio and Antonio Damasio, “Investment Behavior and the Negative Side of Emotion,” Psychological Science, vol. 16, no. 6 (2005): 435-439.
• Meir Statman, What Investors Really Want, McGraw-Hill, New York, 2011