Published June 10th, 2017
John Howe is the author of The Foolish Corner: Avoiding Mind Traps In Personal Financial Decisions.
He is an expert in behavioral finance. Individual investors have historically significantly under-performed the market – despite saving on fees. One of the primary reasons for this is because we all suffer from biases and blind-spots that make our decision making far from perfect.
Recognizing these deficiencies is the first step in overcoming them. The interview below shares several important insights and thought constructs regarding individual investing and behavioral finance. A few topics covered are:
- Confirmation bias
- Myopic loss aversion
- The ‘information fire hose’
Without further ado, the interview is below! Questions are in bold.
First of all, I’d like to give you the opportunity to introduce yourself more personally to the Sure Dividend reader base. What can you tell us about yourself, your experience in finance, and your thoughts on investing?
I have been a Finance professor since 1981, hold the CFA (Chartered Financial Analyst), and have taught CFA prep courses for a major Swiss bank and other institutions. I serve on the boards of directors of two startup companies, and have served on the boards of a bank and its holding company. My primary thought about investing is that it can be fun, although I recognize that many people get stressed out about it.
Tell us some about the contents of your new book and what inspired you to write it.
The book takes a look at personal financial decision making through the lens of behavioral finance. Behavioral finance is the blending of psychology, economics, and finance, and highlights the cognitive biases and limitations that we as humans have. It is a rapidly growing field, and one I feel can be extremely helpful to individuals. I was inspired to write the book because I see people making bad decisions that could be avoided by having an understanding of behavioral finance.
As you say, your book focuses extensively on behavioral finance, a field that I consider to be tremendously interesting and valuable. In your opinion, what are the main behavioral biases that tend to negatively influence investors in the stock market?
Well, there are many to choose from. You can get a brief overview of the ones I cover in the book by looking at the Table of Contents at: http://www.knowthybiasedself.com But as a follow up to that shameless plug, I’d pick confirmation bias as one of the Biggies.
Confirmation bias simply refers to the notion that we humans are quite receptive to information that supports views we already have, and far less receptive to information that does not support our views. So, for example, an investor may fall in love with a stock and thus subsequently ignore information that suggests that the stock is less attractive than he (or she) thinks.
Building on the last question, you have a chapter in your book called “Myopic Loss Aversion” where you discuss how investors dislike losing money more than they like earning money. Why do you think that is?
Let me start with the caveat that I’m not a psychologist. But I can testify that loss aversion is a well-established fact. As you say, humans get much more discomfort out of a $100 loss than they do pleasure from a $100 gain. I would guess that, in times when surviving from one day to the next was far from certain, a loss (of food or shelter, for example) could be fatal, so we’re more sensitive to losses than gains.
Myopic loss aversion can best be illustrated by the image of an investor checking her portfolio many times a day. The changes in portfolio value are frequent, and probably have about as many negative changes than positive changes. But if the negative changes (losses) hurt more, the investor becomes uncomfortable and may end up selling to end the psychological pain. But in the long run, the investment might have been a wise one. As you say, “High quality dividend stocks, long-term plan.”
I will also note that one advantage to a dividend-focused strategy is that those stocks typically fluctuate less, thus diminishing (but not eliminating) the effects of myopic loss aversion.
Investors today have access to more information than ever before, and trading stocks has become very easy thanks to online stock brokers. In your book, you call this “The Information Fire Hose”. Do you have any advice to help our readers deal with the ‘information overload’ of today’s stock market?
I think most investors should ignore the Information Fire Hose (very hard to do) and work at something to increase their income, e.g., taking a second job, starting a company, that sort of thing. There are many areas of the economy where the competition is less than it is in the financial markets. Individual investors should create a diversified portfolio with low expenses; such a portfolio doesn’t need much attending, leaving time for other endeavors. (Even if one has a dividend-focused portfolio, diversification is important.)
You are an academically distinguished individual and hold both a PhD and the CFA designation. In your mind, what is the importance of formal education in the world of investing?
Formal education is not necessary for being a successful investor, but it will increase the probability of success, primarily because it teaches critical thinking. Successful investors are life-long learners, not surprising given the rate of change in the world these days.
What are your thoughts on the importance of emotions in successful investing?
Emotions are important because they often get in the way of good decisions, financial and otherwise. In my book (shameless plug #2), I suggest a number of ways to counter emotions and cognitive biases. For example, an investor could appoint someone to be a Devil’s Advocate, who would look for faults in the reasoning of the investor. Another useful tool is called the pre-mortem (the name is suggestive).
If you could give investors one piece of advice, what would it be?
That’s tough. I’d say that investors have to be very skeptical about anything that reeks of a “free lunch.” For example, in today’s environment (June 2017), the promise of double digit interest rates at no risk is simply not credible. The internet is full of misinformation, another reason to ignore the Information Fire Hose. Finally, don’t be fooled by the confidence of talking heads—some research shows that the more confident the forecaster, the less accurate are his/her forecasts.