“Psychology may be the most underappreciated, undertaught, and under-contemplated facet of investing.” -Michael Mauboussin
With chapter 10 of his book, "More Than You Know: Finding Financial Wisdom in Unconventional Places," Michael Mauboussin turned to the role of psychology in the world of investing. As the quotation above suggests, he obviously considers it a critical issue.
Behavioral finance has grown and helped explain many of the interactions between investment and psychology, yet we still have much to learn. In his introduction to the psychology section, Mauboussin recommended that we distinguish between individual and collective decisions. He wrote, “Both are relevant, but collective decision making is really the key when dealing with markets.” (The author does not reference sociology.)
Those collective decisions matter because individual errors often cancel each other out, leaving the potential for an accurate stock price. From that, he argued that diversity may be a necessary condition for a market that functions well. For individual investors, the lesson is that while it is important to have your own views, you also must be conscious of what other people are thinking.
Turning to chapter 10, he pointed to the issue of stress and how it can sabotage our besting investing intentions. And, he delves into the book, “Why Zebras Don’t Get Ulcers” by brain researcher and stress expert Robert Sapolsky. That author made the point that humans are well-adapted for dealing with the stress of short-term physical threats, something that has evolved over our long history.
But we still have problems with psychological stress, and if that stress becomes chronic, can detract from our health and performance. He wrote:
“What kinds of things do we do in response to stress? Sapolsky notes that our reactions are “generally short-sighted, inefficient, and penny-wise and dollar-foolish.” The body mobilizes to deal with the immediate threat. This stress response is effective in a crisis but can be very costly if you experience every day as an emergency.”
Mauboussin then asked why money managers get ulcers, and provided this answer: “The research shows that stress stems from a loss of predictability and a loss of control, where the common element is novelty. I believe that secular trends in the economy and in the money management industry are contributing mightily to the sensation of less predictability and control.”
One of the trends contributing to the loss of predictability is the fast-growing rate of innovation globally. That, in turn, has shortened the average shelf life of S&P 500 companies. Between the 1950s and now, the average life span had dropped from between 25 and 35 years to about 10 to 15 years.
Another trend has been increasing volatility in stock prices. Without reference to dates, Mauboussin argued that market level volatility had been stable, but had been rising for individual stocks since the 1970s. That means, or meant, that money managers have a higher-than-ever risk of holding the wrong stocks.
But managers aren’t facing challenges just inside their portfolios. He reported that shareholders and mutual fund rating agencies are judging the managers at least every 90 days. To avoid negative ratings and job loss, managers try to eliminate as much tracking error as they can. The author added:
“Managing tracking error often requires mirroring the market and generally entails short-term trading. In a sense, reducing tracking error is rational for money managers because there’s no use worrying about how the portfolio will perform over the next three years if you’re out of a job along the way. But closet indexing is not ideal for shareholders.”
Mauboussin went on to argue that the perceived loss of predictability and control was leaving many money managers with chronic stress, and that led to less than optimal portfolio management decisions.
That happens because the psychological response to stress is similar to the response to physical stress, sometimes called the fight-or-flight response. According to Mauboussin, our blood pressure goes up, we send energy to those parts of our body that need it most and our short-term memory sharpens. What are shunted aside are the body’s long-term projects such as the immune system and reproduction.
For managers, he saw stress as encouraging a short-term focus, something that comes out when looking at portfolio turnover. Mauboussin noted that average portfolio turnover had been about 20% in the 1950s, but shot up to more than 100% by today (in this case, that probably meant 2008, the year of the first edition).
Too much portfolio turnover drives up transaction costs, market impact costs, unnecessary taxes and agency costs. In research through to 2006, analyses showed that lower turnover generally correlated with higher returns.
How should they—and we—deal with the stress of unpredictability and loss of control? By striving to maintain an “appropriate” long-term focus. He offered the example of Ulysses, the classical Greek hero of Homer’s epic poem "The Odyssey":
“Ulysses had the crew bind him to the mast of his ship to protect him from the call of the Sirens. Money managers, especially when feeling a loss of predictability and control, are drawn to short-term activity. Like Ulysses, money managers should take the steps necessary to focus on the long term if they are to optimize long-term fund performance. If the source of stress is largely psychological, so too is the means to cope with it.”
Conclusion
Psychological stress is costing us money by reducing the returns of our portfolios, or from the portfolios of money managers.
The programmed response to stress is to take action in the short term and to disregard everything else. When psychological stress becomes an everyday event, we become short-sighted in our investing. One prominent manifestation is higher turnover in portfolios; that, of course, leads to smaller returns.
The solution, according to Mauboussin, is to focus as relentlessly as we can on the long term.
Read more here:
- More Than You Know: The Management Factor
- More Than You Know: The Myopic Loss Aversion Problem
- More Than You Know: What's Behind Investing Hot Streaks?
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.Â
