By Ned Montag, CEO
In the short run, the stock market is very much a fad and fashion business, where the news of the day determines which stocks will be chased higher. All investment styles or methods, no matter how logical their grounding, will underperform the market averages during times when the market’s attention is elsewhere: technology, macro-economics, world politics and many other phenomena can draw the attention of investors in our hyper-speed global environment these days. Periods of underperformance can pose a dilemma for more focused, long-term investors or investment managers. Should I stick with a method that I know to be sound, even if it is not working for now? Should I try to shift my style or what I pay attention to, just temporarily, to participate in the fashion of the day? It can be excruciating to watch other investors make money in “hot stocks” while your portfolio of thoughtfully chosen and/or long reliable stocks is left sitting on the sidelines.
For decades, behavioral psychologists have studied how rats, pigeons and people make choices in times of uncertainty. In a study from the 1960s, essentially replicated in the 1980s, psychologists placed pigeons in a box that contained two feeding keys. If a pigeon pecks the correct key, a food pellet emerges; if it pecks the wrong key, nothing happens. The trick was that one of the keys was rigged to produce a food pellet much more frequently than the other. Once the pigeons, through trial and error, learned the most likely key to produce food, they pecked it relentlessly, thereby optimizing their food supply. This approach, learning the best answer and then applying it relentlessly, is called “maximizing.” This behavior is also observed in similar experiments involving rats or children under the age of four. The lack of self-awareness seems to be present, but it’s hard to really understand what exact variables are at work when this result occurs.
Other experiments involved guessing the results of coin flips or the color of marbles drawn from an opaque bag. In each case, one choice was rigged to occur more than the alternative.
Interestingly, though, when adults are faced with the same experiments, they tend to ignore “maximizing” but instead engage in a strategy called “frequency matching.” This term simply means that adults try to anticipate when the less likely result will occur, and they guess it accordingly in an effort to avoid it. Clever, clever. And somehow by attempting to guess when an unlikely result will occur, adults think they are likely to raise the odds of success.
So given these two paths, if the best answer occurs 60% of the time and the alternative only 40%, why fight that pattern? Well, because a whole psychology emerges from this, driving one to make choices that in fact “feel” smarter. But are they? It is hard to tell, especially in the moment.
Neuroscientists tell us that starting around the age of five, humans develop a module in the left lobe of their brain nicknamed “the interpreter.” This nodule searches for patterns in data and can tempt us to find or guess patterns that don’t actually exist. The “interpreter” probably helped primitive man succeed in hunting and in avoiding being hunted, but it can fool modern man into thinking he/she can predict short-term events at a rate higher than chance.
So, as we consider these behaviors, what are the final results? Well, the “maximizing” pigeons usually scored higher in making binary choices than the pattern-seeking human adults who would change picks based upon “intuition.”
An example: One famous investor who showed extreme pigeon-like tenacity in refusing to abandon a successful investment style is Warren Buffett. In 1969, the stock market was rewarding only the most speculative of stocks, and Buffett determined that his highly successful style would not be rewarded anytime soon. So he decided to terminate an investment partnership that, over 13 years, had achieved a remarkable 31% per annum return for its partners. He sent the money back, something that rarely happens on Wall Street. In his closing letter to investors, he wrote, “I am not attuned to this market environment and I don’t want to spoil a decent record by trying to play a game I don’t understand.”
Never mind that the record was in fact spectacular and not decent.
So, what is the take-away from this reflection on investing? If you have a selection method that is sound, based upon proven selection principles, don’t abandon it simply because the market, for now, is not rewarding it.
It is probably far wiser to be a pigeon and stick with what you know works, than to switch gears in pursuit of the latest investment fad. The odds of increasing your returns long term by switching back and forth between styles is probably low. In the long run, speculative markets fade, and investors re-learn the value of selecting stocks with strong fundamental characteristics. But it can take time.
This lesson is not one to take lightly. Humans are quite given to fads. Behavior is contagious, especially when fashionable thinking becomes a priority. Your “crowd” and frankly, any crowd, has heavy influence on your choices, and the single most powerful factor in any investment record is who you choose to have as part of your decision-making team. That, more than anything else, matters. We are grateful to our clients who have chosen to bring us into their situation and let us make important contributions to the financial path they travel. We take that assignment very seriously, know we are accountable for the results, and spend a lot of time analyzing and rejecting fashion trends that constantly circulate in our work. Discipline and sobriety are critical to us, and we prize the trust we earn.
Let me acknowledge that the inspiration for much of this note came from the writings of Morgan Stanley strategist Michael Mauboussin, who has studied how investors make decisions for decades.
The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed. MONTAG employees do not provide legal or tax advice. For specific legal or tax matters, you should consult with your own legal and/or tax advisors. There are risks associated with investing in securities. Investing in stocks, bonds, exchange traded funds, mutual funds, and money market funds involve risk of loss. Loss of principal is possible.
