Performance and Behavior – Part 2

Last month we considered the idea that investor behavior accounts for far more of the real-life returns in an investment portfolio than investment performance. In fact, we showed how the Dalbar Corporation in their annual Quantitative Analysis of Investor Behavior, indicates that the average stock fund over the past 20 years had an average return of over 4 percent more – per year – than the average stock fund investor.

If this premise of “behavior trumps performance” is really true, then how can we explain the investing world as it has existed for decades? There are billions of dollars spent on advertising, analysts and infrastructure in this behemoth system of financial services that communicates and supports this message: “We can help you time the market just right. We can help you choose the best stocks to beat the market. Your investing troubles are over. We can be your guru.” How do they make investors believe this? Basically, they baffle them, charm them and appeal to their emotions. They use every psychological fallacy, influence technique and emotional entreaty “in the book” to enact their plan of compliance. And it undoubtedly works with great efficiency and effectiveness.

I wish we could take the time and space here to talk about all of the techniques they use. JWA University has featured several books over the years that would explain many of them (such as Paradox of Choice, Economic Facts and Fallacies and Why Smart People Make Big Money Mistakes). But let’s focus on just three emotional compliance techniques to make the point.

1. Appeal to Bias (or the Confirmation Bias)

X is true because I desperately want to find any possible evidence to confirm my bias and will selectively ignore anything that does not.

OR, for example:

The financial advisory system is structured so that “experts” can advise which stocks, bonds and other financial instruments can be selected and timed to provide superior returns on a consistent basis.

This line of reasoning is fallacious because it has no bearing on whether the belief is true or false. Just because the financial industry has successfully conveyed that this is a true statement does not support that the statement is true. But what a powerful impact this assumptive attitude has had. Ask any man or woman on the street what an investment advisor does and you will get an answer that contains similar components to “they help you pick winning stocks and advise you on when is the right time to invest.” Both are exercises in futility.

2. Appeal to Authority (or the Expert Fallacy)

Person A is (claims to be) an authority on subject S.

Person A makes claim C about subject S.

Therefore, claim C is true.

This is a sister fallacy that often times simultaneously appeals to the Confirmation Bias and exponentially increases the behavioral influence over its victims. The Financial Industrial Complex will often parade what they claim to be “brilliant economists” who are adept at making the most accurate macroeconomic forecasts. Then they march their Chief Investment Strategist out to all the business talking head shows to convey the market metrics that coincidentally just happen to simultaneously promote his/her fund or fund family. The truth is that no matter what the market or economic topic might be, there will consistently be a healthy balance of “experts” taking either side of the claim made to the investing public. This gives investors ample opportunity to selectively cherry pick the experts willing to defend and deliver a “solution” that caters to his/her biases. These highly educated, highly paid, highly positioned executives make the case compelling. You can begin to easily see the pattern that is emerging with the coercing techniques. You are also catching on quickly I’m sure, that these are transferable to any walk of life in which one might want to make a point. Politics comes to mind…

3. Appeal to Emotion

Favorable emotions are associated with X.

Therefore, X is true.

This one may be the most effective and insidious of the three we have chosen to discuss. It is so simple and immutable. It works in almost any situation concerning any topic. But let me challenge you to do something that you will find intriguing. One evening while watching TV, just do an unscientific survey of the appeals to emotion in the commercials you see. Yes, this means you will actually have to watch them instead of fast forward through them. But within two to three hours, you will be fascinated with what you see. Note the recurring grandparent themes, or “saying goodbye”, and the number of ads featuring dogs! (To make it even more fun, make a note concerning financial advertisements only.)

I think you would agree that believing something simply because A) you are looking to confirm your biases, B) an “expert” said so, or C) “it makes me feel good”; is NOT how a wise and prudent person makes good decisions. These items speak to the very essence of behavior – which is what we already emphatically stated – is the key to success.

So how do you feel when you consider how these and many other compliance techniques are employed on you constantly? Hopefully, by simply being reminded that techniques such as these exist, you may be able to inoculate yourself when they are used against your best interests.

Next time we will delve into some more practical applications of proper behavior as we consider the virtues of patience and discipline when it comes to investing. You may be surprised when you learn what these terms really mean to the wisdom based investor.

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