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Continuing with our Bias mini series in part 4, we look at Loss Aversion, Endowment Effect, as well as Oversimplification Tendency.

Loss Aversion/endowment effect

Loss aversion is peoples’ tendency to strongly prefer avoiding losses than obtaining gains. Closely related to loss aversion is the endowment effect where people place a higher value on a good that they own than on identical good that they do not own. Ever noticed how the home or car you’re selling tends to be a little better than the others for sale?  Loss aversion/endowment effect can lead to very poor and irrational investment decisions whereby investors refuse to sell loss making investments in the hope of making their money back.

The loss aversion tendency breaks one of the cardinal rules of economics; the measurement of opportunity cost. To be a successful investor over time you must be able to properly measure opportunity cost and not be anchored to past investment decisions due to the inbuilt human tendency to avoid losses. Investors who become anchored due to loss aversion will pass on mouth watering investment opportunities in order to retain an existing loss making investment in the hope of making their money back.

In our view, all past decisions are sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost. In order to increase our focus on measuring opportunity cost we look at portfolios like a “football team” where we have the ability to put a limited number of players onto the paddock at any one time. This forces us to focus on the opportunity cost of retaining an existing investment versus making a new investment in the portfolio. We believe many investors would make superior investment decisions if they constrained the number of investments in their portfolios as they would be forced to measure opportunity cost and make choices between investments. This discipline can also result in forcing the sale of “good historical performers” to free up capital for the new opportunity, reducing the risk of both forms of Anchoring Bias.

This discipline has a number of additional benefits:

  • Less portfolio transactions – less transactions almost always means less overall cost and less impulse decisions
  • More portfolio concentration generally allows for greater returns.  Diversification is important to a point, however beyond that point, further diversification simply diminishes the opportunity for any individual investment to make a meaningful contribution to return.
  • Less impulse purchase decisions – As our brains are hardwired to make decisions based on emotion, it is often difficult to make investment decisions based on pure rational analysis.  We are also attached to our past decisions and as such, as less likely to want to sell an existing investment.  If we are forced not only to work out what to buy, but what to sell to fund it, we have a much better method for measuring opportunity cost.  Is this new opportunity really that much better than what I already have?

Warren Buffett often gives the illustration that investors would achieve superior investment results over the long-term if they had an imaginary “punch card” with space for only 20 holes and every time they made an investment during their lifetime they had to punch the card. In Buffett’s view, this would force investors to think very carefully about the investment, including the risks, which would lead to more informed investment decisions.

Oversimplification Tendency

In seeking to understand complex matters humans tend to want clear simple explanations. In our experience there tends to only be a few main factors that influence the result.  This is often referred to as the “Law of Disproportionate Influence”. Focussing on these “Greater Influencing” issues produces the best result as they provide the greatest return on effort.  Wasting time or resources on less important matters, particularly those you have little or no influence over, is a common but costly inefficiency.

Unfortunately some matters are inherently complex or uncertain and do not lend themselves to simple explanations. In fact, some matters are so uncertain that it is simply not possible to see the future with any clarity. This is of particular importance when assessing risk as a small amount of the wrong risk can have a devastating effect on wealth.  In our view, many investment mistakes are made when people oversimplify uncertain or complex matters.

“Make things as simple as possible, but no more simple” – Albert Einstein

A key to successful investing is to stay within your “circle of competence”. A key part of our “circle of competence” is to concentrate our investments in areas that exhibit a high degree of predictability and to be wary of areas that are highly complex and/or highly uncertain. We believe that selecting managers with a proven investment process with the discipline and resources to manage that process is relatively foreseeable over the next 5-7 years and is well within our circle of competence.

Many investments however are far more complex and we are disciplined to try to ensure we do not overly simplify the inherent complexity of an investment, regardless of its promoter, theme etc.  Supporting research is also a key ingredient however it is important to understand the analysis, not simply look at the rating.  Over the years we’ve encountered many investment products (particularly “structured” products) that have apparently received “good enough” ratings only to end in disaster.  This was particularly prevalent in the mid 2000’s in the lead up to the GFC in 2008, as credit products of all kinds were being promoted with “AAA” ratings.  In reality though, many of these products were targeting or promising returns well above “normal” AAA rated and as such could only do so through “financial engineering”.  Given that golden rule of investing:

“Financial engineering cannot create return, it simply transfers return from one party to another.  If you can’t be sure which one you are, best not to play.”

If we cannot understand the complexity of an investment or financial product we simply will not invest, no matter how compelling the “simplified” investment case may appear. Notwithstanding our investment research capabilities ad the fact that we have access to the best and most experienced research teams in the country, there are many investments that we believe are simply too difficult to assess with any reasonably degree of certainty.  Moreover, we also have to find something to sell and against this, few “complex” investments ultimately stack up.

 

Inspiration and content for this series has been obtained from a number of sources in particular, Magellan Asset Management and Platinum Asset Management.
Matt Battye

Matt Battye

CEO, Financial Adviser

Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.

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