Jack's Two Cents
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What I've Learned in 40 Years.
by Jack Oeming, CIMA®
Published March 26, 2019
When I was younger I thought the older you get, the smarter you become. “Experience will guide you to the correct decisions,” I thought. Now I’m not so sure. Will certain sets of facts always lead to the same factual result? Or, is that just a heuristic trap based on hindsight?
We need to remember that “facts”, or at least our memory of them, change. Let me use the example of the current rising interest rates and the perceived negative effect those rates are expected to cause for the economy and the stock markets. In November of 1978 when I entered this business, the Dow Industrial average stood at 800 and the long Treasury bond was yielding 8.79%. In September of 1981, the yield jumped to 15.08% and the Dow had risen to 852. When long bond interest rates fell to the low of 2.1% in July of 2016, the Dow stood at 18,432. Over the next 2 years interest rates rose to 3.4% while the Dow climbed to 25,538. So, any rule of thumb that rising interest rates always causes the market to fall isn’t necessarily true. There’s a myriad of other factors that move the prices of equities higher and lower.
Since there is no absolute way to predict an outcome with certainty, investors must recognize they carry biases that are based on emotions. Unchecked, those biases can impact their financial decisions. Hindsight bias, recency bias, and herd mentality bias tend to lead investors down the wrong path. Rules of thumb aren’t really rules at all, and heading down the wrong path can be financially difficult to recover from.
Hindsight is a tricky bias. That’s because salient points may come to the forefront of our memories, but not all the circumstances that led to the event itself. What’s more, there are most likely other facts that weren’t available to the individual, either during the experience or in trying to recreate the event in their mind.
Let’s revisit the rising interest rate example. What were the other factors causing the markets to rise while the interest rates rose? How much debt was being relied on to fund normal lifestyles and future growth? When interest rates fell to their lows, how much debt was on their balance sheets at that time? These questions are likely overshadowed by memories that were stressful during that time. Thus the hindsight of the event would have a larger, more pronounced effect on future decisions.
Recency bias and herd mentality are very similar. Think back to the technology and internet bubble of the late 1990’s and early 2000’s. As fortunes were made overnight, and as the excitement spread from one individual to another, it created a classic bubble. The introduction of “Hot” deals for the newly rich opened the door to a new group of investors. This caused a stampede into the market as later investors joined the herd. The bubble grew until the blow-up of 2002 when it burst. Many investors saw up to 90% of their portfolios evaporate. This event caused a lot of people to avoid stock markets and move into the real estate and fixed income markets. Instead of finding a refuge, they walked back into another bubble trap in 2007.
How can you avoid these traps? Don’t allow current events to dissuade you from making smart, long- term decisions. Step back, take a calm and rational approach with the help of your trusted investment advisor. Their training is based on a sound and focused plan, defined to help you succeed through a non- biased process.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Advisor. Fixed insurance products and services offered by The Oeming Group 2282 Oakmont Way Eugene, OR 97401 541-228-9925
Are You Worried About Your Success?
by Jack Oeming, CIMA®
Published September 28, 2018
Sustained success can lead investors to worry about the end of the rainbow and the eventual decline in their portfolio. While there are many things that cause this, two specific biases come to mind : worry bias and hindsight bias. These are common biases that can undermine your long-term investment success, which is why you should consistently go back to your long-term financial plan and confirm that all your goals are still correctly aligned.
What is worry bias?
Worry is a natural and common human emotion. The memories of past scenarios sometimes alter future decisions. Anxiety can be created when a portfolio increases in value and investors see their returns grow. This can cause an investor to worry about their portfolio, and this worry can lead to the abandonment of their financial plan.
So how can an investor proceed when the fear of a loss is so strong it could cause them irreparable damage? Start with a review of your focused financial plan. This plan should have already allocated assets into the categories of short-term needs, near-term liquidity goals, and long-term investing. Decide if anything has changed in the first two categories. Does the recent success of your portfolio require more liquidity or less? Have short-term and near-term goals changed? If nothing has changed, maybe you’re a victim of certain biases. The more you know and plan for your own future, the easier it is to ignore the vagaries of the markets future. Learn to control what you can control and rely on your advisor to help through the rough spots.
What is hindsight bias?
Like the seasons of the year, people believe that they can predict the economy or the financial markets. And like the seasons of the year, there can be similarities during periods of improving or declining economic growth. These similarities can lead to hindsight bias. If the summer the year before was hot and dry, will this year be the same? If the economy grew at a 3.5% rate for 2 years during the last expansion, will we see the same again this time? The simple answer is “no one knows”. The economy and markets are like the weather. They cannot be consistently and successfully predicted over the long term. Just because the weatherman correctly forecasts the weather for tomorrow, it doesn’t mean his forecast for a date 8 weeks in the future will be completely correct. There are too many variables involved to predict a precise outcome. Especially when predicting long-term economic results.
Being able to control your emotions during times of stress will help reduce the effect that biases have on you. Controlling your emotions is more important to your financial condition than being able to, occasionally, predict events in the economy. When you try to predict the future of the economy, or the weather for that matter, your chances of success are limited. Your best chance of success in reaching your financial goals lies in staying focused on your own needs and being steadfast in following your plan.
Behavioral Wealth Advisement
by Jack Oeming, CIMA®
Published August 24, 2018
I have recently added a new business title: Behavioral Wealth Advisor. As my title suggests, I can help individuals cope with the changes in their financial plans and investment portfolios. The economy and the investment markets are unpredictable. This unpredictability leads to both worry and concern. Their behavioral responses to these concerns may have caused many to react badly, resulting in permanent investment portfolio losses and severely damaged financial plans. This is why I decided to improve my knowledge of behavioral economics and behavioral finance.
It is my hope that my clients, friends and family will now be able to use this knowledge I have gained from completing the course to better cope with the volatility inherent in their financial lives. Please contact me if you would like to know more about this valuable service.
Trapped and Frozen by Your Fears
by Jack Oeming, CIMA®
Published June 18, 2018
Recently I have been hearing that interest rates are on the rise. As this news swirls throughout the news, I have been getting more questions about what to do now and how to avoid the decline coming because of higher interest rates. The fearful investor quotes similar events in history and voices concerns that this event will cause the economy to stall, equity prices to dive, and retirement portfolios to disappear. Their panic rises even more when the Federal Reserve announces an increase in fed funds. This sometimes causes shudders in equity prices. It doesn’t always cause this reaction, but when it does, it leads the panic-driven investor down a path in which they get trapped by their own fears. These fears stem from heuristics, or ‘rules of thumb’. In this case, the past reaction to rising interest rates seems to cause stock prices to decline. How should an investor combat their own fear to avoid destroying their well thought-out, long-term financial plan? First, remember this is not the first time that interest rates have changed direction. Not all of those changes caused negative results. The smart investor takes a step back and sees where their assets are allocated and whether their long term plan is prepared for temporary adjustments in the interest rate environment. Are you prepared for the volatility that is normal in the equity market? Disruptions and negative events are a part of our lives. The key to surviving these events is to not let your fear dictate your actions through misguided reactions.
Negative events can, and do, cause short-term disruptions in the equity markets. Terror attacks, war, political turmoil, severe weather, or natural disasters have all caused short term declines. Event driven movements can produce both positive and negative results. In many cases, event driven market movements are short term in nature. Hindsight bias weighs heavily on the mind of the investor. What happened in the past makes an individual react in a way that seems to fit the current situation. The problem is, the memories of past events have little or no basis of fact on the events taking place now. It is easy for someone to think back to the last time a similar event happened. This can create an anchoring bias. The mind gets locked to the results of previous events and causes them to freeze or react in a negative fashion. If the last time a similar event resulted in a positive or a negative outcome, the person will most likely believe this time will result in the same outcome.
People often take a negative outlook when viewing surprise events. This negativity bias happens when someone finds it easier to focus on the bad news. This causes them to deny any positives that exist in the current situation. And by waiting for confirmation of their fear, they also risk finding out they are wrong. Their justification for this action is risk management. This bias can and does result in opportunity losses. The effects of perceived risk outweighs the probability of the rewards they seek. In my years as an investment adviser, this has been the bias I have witnessed the most. The average investor is best served having an adviser to combat the negativity bias, thus helping them to succeed. At the Oeming Group, we’re here to help you navigate the best path to reaching your goals, no matter what the market happens to be doing at the moment.
Is your financial future based on the perceptions of your past experiences?
by Jack Oeming, CIMA®
Published August 16, 2017
The emotion of fear can be a potent detractor when someone is trying to make important decisions. Fear is rooted with uncertainty. Being fearful can push a person to be overly pessimistic when addressing an unknown outcome. In other words, actions based on feelings, rather than facts, can cause the decision maker to make the wrong decision due to fear created from past actions or events.
Fear does help avoiding some disastrous situations. The emotion of fear is deeply rooted in the brain’s amygdala. The amygdala controls the reaction to fight or flee. This reaction occurs when someone is unsure of what to do with a perceived dangerous situation. As the decision maker learns more facts about the problem, uncertainty wanes and fear subsides.
Let’s look at just two biases that can hurt your long term success as investors.
The first is Loss Aversion Bias.
A good example of this is the car that becomes a “money pit”. Say you own a car that you have had for several years and recently you have been having several mechanical problems. Instead of moving on and selling your current vehicle and replace it with one that is in better shape, you continue to hold on to the original vehicle due to the sunken cost of past repairs. Not wanting to admit the decision to hold is wrong, you continue to sink more money into the bad decision. This is also known as the “sunken cost fallacy”.
Another example is the gambler who loses on his first attempt at their chosen game, He can become a victim of loss aversion. After realizing the first loss they tend to play again, to attempt to recoup the previous lost money. This can become worse if he wins a few and loses many more times.
The person who believes they are getting something touted as being scarce creates one of the most potent definitions of loss aversion. While shopping, for example shoes, you see the ones you feel are ideal. Even if the cost of the shoes are not in the price range you are willing to consider, the anxiety of not getting them causes a loss aversion. This can result in the purchase.
Investors are very susceptible to loss aversion. Imagine you have a stock in your portfolio that is down so much that you can’t stomach the thought of selling? It’s possible, if you sold the stock the money that is left could be reinvested into a higher quality stock. Because you don’t want to admit that the loss has gone from a computer screen to real money, you hold on in hopes that you will make it back to even.
The best example of this was a company called Enron. In the summer of 2001 the stock price topped out at more than $90 a share. By the end of 2002 the price dropped to zero. I personally witnessed several investors who lost their entire investment because they would not face the loss.
I had a client who loved General Motors in the late 1970’s. It represented a large percentage of their portfolio. When the car company was facing significant financial problems, they still would not consider selling because they didn’t want to take the loss. The ultimate loss was devastating to their portfolio.
The financial debacle of 2007 and 2008 was particularly devastating to investors who refuse to recognize their losses. Washington Mutual investors joined the ranks of Lehman Brothers, AIG, Citigroup, and a myriad of other financial institutions. This caused many of their investors to ignore the problems and fall victim to their personal bias of loss aversion.
The second bias that is closely related to loss aversion it is the endowment effect.
The phenomenon in which most people would demand a considerably higher price for a product that they currently own rather than the same item they don’t own. Their fear revolves around losing something perceived as having a higher value than the same item in the open market. So if you own something, you tend to place a higher value on it versus what someone else might value the item.
An example of this, originally published by Richard Thaler, could be of someone who owns a coffee mug. The owner of a mug required significantly more money to part with their possession (around $7) than randomly assigned buyers were willing to pay to acquire it (around $3). The owners’ loss of the mug loomed larger than buyers’ gain of the mug.’ Simply put, the endowment effect says that once you own something you start to place a higher value on it than someone else would.
Inherited items can also lead to the endowment effect. An example could be the case of the ugly dresser. Maybe it was a dresser that was bright pink with orange stripes that belonged to a cherished ancestor. While the dresser may have fit the style and taste of your loved one, you personally do not prefer a dresser that is bright pink with orange stripes. Because you now own the dresser once belonging to a cherished family member, you refuse to sell it for anything less than $600, even though a consumer could find a comparable item for much cheaper from say, a department store. If everyone who owned a dresser asked an unreasonably high price simply because it's theirs, consumers would be faced with the tough decision to either go without a dresser, pay a price much higher than its value, or try to find another dresser.
It’s important to avoid biases when you are making important decisions. It is impossible to continually avoid them, but training yourself to recognize their existence can help train you to avoid mistakes.
Behavioral Finance: What is a bias and why do they matter?
by Jack Oeming, CIMA®
Published April 7, 2017
A bias is the preference or inclination to inhibit impartiality and promote prejudice in decision making. It is the personal prejudice used to rationalize a response. A bias used to rationalize the outcome may or may not be correct. An individual believes they are correct, due to the rational thought and models they used to achieve their answer. In some cases they are wrong, because they don’t recognize their own biases are leading them to a faulty answer. The rational person believes their decisions are based on known facts. The problems arise when their own biases lead them to their answer.
When an individual uses advanced models and data formulas to define their solution, they believe their answer is founded in facts and must be correct. This is the illusion of control. Just because a significant amount of intellectual work is used to identify and find an answer to a problem, does not necessarily mean the solution is completely correct. Many other biases, such as framing of the problem, hindsight, stereotyping, and overconfidence in one’s abilities, can lead the individual into believing they are in control.
Framing bias refers to how a decision maker views a problem. The decision frame depends on how a problem is formulated through the perception of the individual decision maker. By changing the wording of a problem the answer could be completely different even when the facts are identical. For example, it sounds more positive to say that a new product launch has a "1-in-10 chance of succeeding" compared to the mathematically equivalent statement that it has a "90% chance of failing." If people are rational, they should make the same choice in every situation in which the outcomes are identical. It shouldn't matter whether those outcomes are described as "gains" or "losses" or "successes" or "failures." But, the choice establishes very different frames, and decisions may differ because of it.
The hindsight bias reflects a tendency to overestimate your own ability to have predicted or foreseen an event after learning about the outcome. There are many possible examples of hindsight bias. Here is just one: Three friends decide to bet on a horse race. One of them breaks from the other two and chooses a horse with very low winning odds, saying that he has a good feeling about that horse. The long shot ends up winning, prompting the friend to claim he’d been certain of the outcome.
Stereotyping bias is similar to hindsight bias. The decision maker uses their past conceptual views to make quick decisions. The results are often rooted in their memory of similar passed events. Stereotyping makes people generalize things. There are both positive and negative stereotyping. A positive example would be: Asians have high IQs. They are smarter than most in Math and Science. These people are more likely to succeed in school. A negative example would be: All politicians are philanders and think only of personal gain and benefit.
Overconfidence bias arises out of the perceived success of other biases, leading the decision maker to believe they have above average abilities. A good example is 93 percent of the U.S. students estimated to be “above average” drivers. Without the overconfidence effect, that figure should be exactly 50 percent—after all, the statistical “median” means 50 percent should rank higher and 50 percent should rank lower.
This is why it is important to recognize the negative impact a bias can have on results. It is not necessarily bad to interject a bias into a decision model, it’s just that an individual can’t rely only on their own emotions to solve complex problems. It is a necessity to use rational thought and an intellectual fact based process to help offset the mistakes of using just one process.
The best way to achieve success in a decision making model is to recognize and identify biases that could affect your decision process. I have identified only 4 biases that may lead to faulty decision making. This is why we recommend utilizing a caring and thoughtful financial planning team to guide you through your decision making process. In this way you could prevent making some unfortunate mistakes due to those common biases.
by Jack Oeming, CIMA®
Published December 9, 2016
Why do some investors succeed and others fail? Why do some people believe they can “beat the market”? Is it possible to know when to buy and when to sell based strictly on the economy or financial information? In this space, I will explore a theory that concludes investors financial success is also controlled by heuristics, biases and emotions.
What is behavioral finance and how is it different than traditional standard finance?
Standard finance defines a total portfolio goals and risk level based on a single entity. Behavioral finance views a collection of individually focused accounts reaching each individual goal. This allows the investor to adjust their risk tolerance to meet each individual saving or investing goal. In doing so the investor may use their emotions and cognitive biases to better achieve their desired results for each portfolio.
Standard finance (also known as modern portfolio theory) relies on models and formula’s based on past financial data points to explain how investors should make their decisions. Standard finance is built on four foundation blocks:
- People are rational
- Markets are efficient
- People should, and do, design portfolios by rules of mean-variance(*) portfolio theory
- Expected returns of investments are described by standard asset pricing theory, where differences in expected returns are determined, only, by differences in risk.
These decisions are thus considered rational and efficient.
(*) mean-variance: the return difference from the average return of the market benchmark also known as Alpha.
Behavioral finance augments and modifies standard finance by recognizing emotions and personal biases and how they enter into the investor decision making process. It is the combination of economics and psychology explaining a decision process that is considered normal.
Behavioral finance offers an alternative foundation to the foundation blocks of standard finance. According to behavioral finance:
- People are normal
- Markets are not efficient, even if they are difficult to beat
- People design portfolios by rules of behavioral portfolio theory
- Expected returns of investments are described by behavioral asset pricing theory, where differences in expected returns are determined by more than differences in risk.
What is the difference: Standard finance is rational and behavioral finance is normal.
How can the average investor improve their long term returns with the knowledge found in understanding Behavioral Finance? Understand yourself and your proclivities to using your emotions and biases to control your decision making. By understanding heuristics and biases in conjunction with standard finance decision making, the investor can possibly improve their long term performance.