“Buy low, sell high.” This is one of the most commonly known investment sayings. Have you ever considered it more deeply? What are the assumptions? For example, how does one define “low” or “high”? What people actually think is: “low is where I bought it, therefore, to sell high I should wait for the price to go higher than that.” Does that make sense though? Does the marketplace of supply and demand care about the price that you or I bought or sold a stock? Rationally, we understand that it doesn’t. There is a myriad of information informing the price of stocks every day, and today’s price is completely independent from the price 3, 6, or 12 months ago. In fact, trying to invest this way is not rational—rather, it is biased by our own emotions such as fear of loss and feeling better about sticking with current positions (so we don’t regret it if they go up). A better investment approach is to be aware of the psychology that leads people astray, and then make choices to overcome those biases. There is a lot of psychology to investing and much work has been done to analyze it.
In this article, Vident’s SVP, Head of Portfolio Management and Trading, Rafael Zayas, and Vident’s Director of Adviser Solutions, Russell Ayan, do a deep dive into investment biases and how the investing process underlying SMAs (Separately Managed Accounts) avoids them.
Systematic investment approaches, such as those used by Vident to manage SMAs and funds, offer numerous benefits. Those benefits include tax-efficiency*, customization, and values alignment. Other benefits of systematic investing relate to investor psychology. Understanding how investors can potentially undercut their own portfolio performance is relevant to all advisors and fiduciaries, especially when behavior can be driven by common biases or thought patterns. There are many behavioral biases that have been identified by researchers who study these behaviors. This article focuses on three in particular; anchoring bias, loss aversion, and the endowment effect, and discusses how Vident’s approach can help mitigate the impact of those biases.
Anchoring Bias
In our daily lives, we encounter anchoring bias in various ways: from evaluating the prices of items “on sale” (even if the base price is inflated) to perceiving professional sports players based on their draft position. In the context of investing, this commonly occurs for data such as initial purchase prices, or a profit or loss number. With the original “anchor” number in mind, people may make subsequent decisions irrationally centered on that number. A common example is when people continue to hold a stock position below its initial purchase price (thus at a loss) despite the fact that the purchase price is only relevant to the individual. It is not reasonable to think that the original purchase price serves the person’s investment objectives or has importance to the overall stock market. For SMAs, trades are considered in the context of the entire client account. Trades are evaluated by how well they align the client account to its objectives, net of taxes for taxable accounts. The client’s objectives are defined by the target strategies assigned by their advisor and managed by the investment team. While it’s true that the purchase price of securities has an impact as far as the tax consequences for a taxable client’s account, the gain and loss is considered only for taxes, with small deviations from the purchase price having a proportionately small impact on the trading process.
Loss-Aversion Bias
Loss-aversion bias refers to how people have much more strongly negative feelings towards losses than they have positive feelings towards generating gains. This differs from the anchoring bias; it’s less about the specific numbers related to gain or loss and more about the intensity of our reactions to losses. Examples include how painful concessions may feel in negotiations, or not speaking up in meetings due to fear of rejection or judgment, even though someone may have a valuable insight to share. As far as investment decisions, the aversion to losses may lead people to make suboptimal or irrational decisions if a trade or a position has led to a loss. Rather than looking forward, the pain of realizing the loss may lead one to hold onto a position when otherwise one wouldn’t. The flip side of this is true as well. People feel better realizing a gain, so they tend to sell the winners in the portfolio instead of letting those returns compound. Using a systematic approach, positions held at a loss are only meaningful for taxable accounts, where there may be the benefit of loss harvesting, and those that have gains are held in order to defer the tax impact. In this case, the process will sell stocks at a loss in order to improve the client’s after-tax return and defer realizing gains in highly appreciated stocks. Absent the tax constraints, SMAs will prioritize tracking the client’s investment objectives without any biases related to the gain or loss in some positions, sectors, or other parts of the market.
Endowment Effect
The endowment effect is explained by how people may value an asset they hold more than they would if they did not hold it. For instance, this effect is evident when car dealerships offer test drives, companies distribute free samples, or individuals price their used items significantly higher than what it would cost to buy the same items new. For portfolio management, individual investors are prone to hold onto stocks already in the portfolio. Rather than reallocate into other stocks that may have better chances of outperforming, investors are prone to hope that the stocks they have will be the winners. It is challenging for investors to weigh the opportunity cost of holding the current positions versus switching into new positions. This act of “omission”, or intentionally not changing the positions even when they underperform, is less painful psychologically than the act of “commission”, where the investor changes positions only to find the original positions do better. In the context of SMAs, the systematic investment process does not value current holdings except in the context of their tax effects for taxable accounts. This allows the accounts to turn over the portfolio as required to keep up with changes in the target investment strategy.
Conclusion
In essence, emotions and behavioral biases can often drive investors towards irrational investment decisions. SMAs provide a systematic process to avoid such biases, aiming to give investors a better chance to effectively reach and hopefully exceed their comprehensive investment goals. If you’re looking to make informed and rational investment decisions, consider exploring the benefits of SMAs. Take the next step towards a bias-free investment journey and reach out to a trusted financial advisor today.
* There is no guarantee that tax optimization may be achieved. Vident Asset Management (“Vident”) does not provide tax advice. Tax efficiency of any product or investment generally or compared against another cannot be guaranteed.
All information and opinions expressed herein are current as of the date of original publication and are subject to change. Discussion of securities is not a recommendation to purchase or sell. Readers should not rely on this discussion in making future investment decisions. Investing involves the risk of loss.