None of Us Is Homo Economicus

Editor's note: The markets and our offices are closed on Monday, June 20, in observance of Juneteenth. Because of this, we won't publish Altimetry Daily Authority. Please look for your next issue on Tuesday, June 21.

In investing – and in general – nobody is completely rational...

One of our U.S. analysts is preparing for the chartered financial analyst ("CFA") Level III exam. Aaron's CFA studies include behavioral economics... or how psychology influences economic decisions.

Within behavioral economics, there's a theory called homo economicus. It suggests humans have the ability to be totally rational.

Sadly, we know better. When money is involved, rationality often flies out the window.

We're not immune to this at Altimetry. When we're looking at stocks, I (Rob) will frequently find data that lines up with our thesis. Aaron is quick to yell out "confirmation bias."

And when we're working on idea generation, he's quick to keep us in check if we're not thinking rationally.

It's not just confirmation bias, either. Humans fall victim to plenty of similar distortions... You may have heard of information bias, hindsight bias, or anchoring bias (more on these shortly).

As a group, these are known as "cognitive biases." They're thought to happen because the brain develops shortcuts when thinking. These shortcuts can help us efficiently process information. But sometimes, they lead to faulty logic.

Let's take a closer look at some cognitive biases...

A lot of the research on this subject came from two of the greats in the field, Amos Tversky and Daniel Kahneman.

The psychologists conducted experiments about decision-making biases. In the process, they practically created the world of behavioral economics by accident.

One of their discoveries was the "endowment effect"... The idea that you value something more if you already own it.

For example, if you were to put a coffee mug in front of your friend and ask him what it's worth, he might say $5.

But instead, let's say you give your friend the coffee mug. A little later, you ask him how much it will cost to buy it back. He says $5.25. Because he now owns the coffee mug, it's worth more to him.

This is totally irrational, but it's how many people think.

The biases I mentioned above are far riskier for investing than the endowment effect. They can lead to incomplete thinking and investing "blind spots"...

• Information bias involves gathering more data to feel more confident in a decision, even if that information is irrelevant. In fact, people often make better decisions with less information.
• Hindsight bias, also called the "I knew it all along" phenomenon, is the belief that you could have accurately predicted past events. That leads you to think you can reliably predict future events as well.
• Anchoring bias occurs when you rely too much on a specific piece of information, often the first thing you come across.

It's incredibly important to pay attention to cognitive bias when investing. If you want to learn more, I recommend Kahneman's Thinking, Fast and Slow.

Though not technically an investing book, it's one of the best books I've ever read. It drastically improved how I think about investing and decision-making in general. I hope it can do the same for you.

And there's another cognitive bias that can be even more dangerous to your investments...

I'm talking about loss aversion – the idea that it hurts more to lose something than it feels good to win something.

Loss aversion probably trumps all others in terms of its ability to ruin portfolios.

This bias causes many investors to spend too much time on "bad money." They'll hold losing stocks longer than they should, hoping they'll turn positive. It's all to avoid the pain of realizing a loss.

That's why an investor might irrationally hold on to a stock that's down 30%, hoping it will rally back. When the loss hits 50%, he'll think, "It can't go down anymore. I might as well hold until it gets back to positive." But the losses will keep piling up. He might even ride the stock to zero.

Then there's the guy who sells as soon as his position gets back to breakeven. The stock is back in an uptrend... But he's so scared of losing that he abandons it the first chance he gets.

At Altimetry, we keep these biases in mind as we build rules to avoid investing traps...

To avoid loss aversion, we implement stop losses in our Altimetry portfolios. These prevent us from chasing a stock too far down. If a stock drops significantly relative to where we bought it, and relative to the market, we're out – no matter how much our emotions want us to hold on.

Then, the stock gets put in "time out" for 60 days. At that point, we'll reassess our initial thesis. If it still stands, and if the fundamentals look better, we'll jump back in.

We suspended this strategy during the pandemic. We recognized that markets weren't acting rationally.

The market is still volatile today. But we want to make sure we have risk controls in place. Plus, today's volatility is due to factors we can identify and tie to usual market cycles. So we recently reinstated our stops across all our portfolios.

When the market is telling us we're wrong, we listen... no matter how much we don't want to.

Best,

Rob Spivey
June 17, 2022