Work always tends to slow a bit during the summer, which provides both time to catch up and to relax. Jennifer and I just got back from a few days of vacation, and the smaller crowds there made it clear that the end of summer is just around the corner and once Labor Day is past, the pace will pick up again.
The slower pace may be responsible for my choice of articles below, the first two of which are a bit less numbers-focused and more contemplative than normal. The first article continues the series on cognitive biases, and focuses on confirmation bias which is the tendency to seek out and interpret information to support existing beliefs. The financial planning tip for the month is more a series of tips on how to spend based on research relating happiness and spending.
Lastly, the question of the month looks at how the Fed might further stimulate the economy given that the recovery remains sluggish and additional Congressional action doesn’t appear to be in the offing. As always, feel free to forward the newsletter to friends and family that might find it useful and please direct any questions or feedback our way.
Micah Porter, CFA, CFP®
Cognitive Biases: Confirmation Bias
Micah Porter, CFA, CFP®
In last month’s newsletter, I discussed the idea of heuristics, or shortcuts our brains use to arrive at quick decisions. Much of the time, these shortcuts are both efficient and effective, but they can lead to systematic errors in certain situations. The tendency to commit errors in those situations is known as cognitive bias. The reason for examining these biases is that they can come into play in investment decisions, and recognizing when that occurs and consistently avoiding them makes one a better investor.
The first bias we’ll explore is confirmation bias, which is the tendency to seek out information that confirms what you already believe and avoid information that challenges those beliefs. Once you’ve gathered that information, confirmation bias leads you to interpret that information in a way that supports your belief. Research has shown that the more emotional an issue or the more strongly held a belief the more likely confirmation bias will come into play.
Confirmation bias has an impact in a number of different areas – politics being among the most obvious – but it often comes into play in investing as well. Even among professionals, those who have a strong belief that the economy is headed in a certain direction, or a company’s stock is bound to over or under-perform often show a persistence in that belief even as evidence mounts to the contrary. We follow a number of different forecasters, and it’s always interesting to see how some interpret the latest release of economic data to support their long-standing, closely held belief.
So how can you (and we here at Minerva) recognize confirmation bias and what can you do about it? In terms of recognizing confirmation bias, bear in mind that it is more prevalent and typically stronger when the issue is more emotional or it’s a more long-standing belief. One common situation in investing where this occurs is when investing in company stock. There are tens of thousands of .com workers who remained convinced that their stock options were going to make them rich in spite of increasing indications that the value of their companies was just an illusion.
In terms of countering confirmation bias in the investing realm, there are a couple of steps we follow, which are:
- Seek out opposing points of view and analyze them versus your beliefs. Given the overwhelming number of forecasters and pundits and the vast range of opinions, this isn’t hard to do in investing.
- Where possible, quantify your arguments and try to quantify opposing arguments as well. In investing, most of the time an argument should be at least partially quantifiable.
- Use scenario analysis to estimate the outcome if you’re correct along with the possible outcomes you don’t believe are likely.
It’s impossible to totally eliminate confirmation bias, but following the steps above help minimize any negative impact on your investment approach.
Financial planning tip – Spending and happiness
Micah Porter, CFA, CFP®
We’ve all heard the adage that money can’t make you happy, but most of us realize that’s not quite true. If you don’t have enough to cover the necessities, more money likely does correlate directly with greater happiness. Conversely, the fact that Bill Gates has a few billion more than, say, Warren Buffett likely does not automatically mean he’s happier than the Wizard of Omaha.
Just about all of us fall somewhere between those that can’t cover the necessities and members of the Forbes 400 list. We have enough to make some discretionary purchases, but certainly not enough to buy anything our hearts desire. So how, given these limitations, do we maximize the happiness we derive from our wealth? It’s a question in which I’ve been interested for some time, and the New York Times recently ran an article here covering recent research on the topic, and the findings are interesting.
Before delving into the article, I’d like to explain what we’ve found in working with clients. For us, fundamentally, financial planning is about identifying options. With options identified, you know what your choices are and you have some measure of control over your financial future. Having those options is one of the keys we’ve found to decreased financial anxiety and overall happiness.
These are a couple of things research has found:
Experience trumps material goods – research indicates that happiness from spending money on experiences – travel, education, concerts and the like – is longer-lasting than that from spending on material goods. There are several reasons researchers believe this to be the case and the article discusses these.
Lots of little purchases generate longer-lasting happiness than one big purchase – the psychological term for becoming accustomed to changes in lifestyle – good or bad – is hedonic adaptation. Research indicates that when it comes to purchases, we adapt to both large and small purchases, but the rate of adaptation isn’t directly proportional to the size of the purchase in question. Thus, with a lot of little purchases, it takes longer for the increase in happiness to dissipate.
Wait, and reward yourself – studies showed that anticipating a purchase increased happiness. By waiting to make a purchase – particularly if the purchase was a reward for a goal met – buyers experienced increased happiness. This dovetails nicely with advice any financial planner would give about saving for a purchase as opposed to buying on credit.
Ultimately, we view money as a means to an end, and that end is to increase the quality of life for ourselves and those we care about. Given that it’s a scarce resource for just about all of us, understanding how to maximize our happiness when we spend can help us in achieving the overall goal of better quality of life.
Client question of the month – What can the Fed to to further stimulate the economy?
Micah Porter, CFA, CFP®
The most common action the Fed takes to stimulate the economy is to lower the interest rates. Lower rates lead to increased borrowing which in turn leads to increased economic growth as the borrowed funds are invested. However, at this point rates are nearing as low as they are likely to go leaving the Fed little room for further decreases. Thus, moving forward the most likely tool the Fed will use is known as quantitative easing, a term you’re likely to hear more of in the coming months.
Quantitative easing involves the purchase of financial assets – typically bonds – by the Fed. These purchases have a couple of primary impacts as follows:
First, by buying bonds the Fed increases the supply of money in the economy which should, in theory, increase the amount banks have to lend.
Second, the purchases increase demand for bonds thereby driving interest rates down in the markets. Lower interest rates should lead to greater borrowing and ultimately greater economic growth.
Lastly, lower interest rates on the securities the Fed purchases – often government securities like Treasury bills and bonds – may lead investors to look elsewhere for better returns, thereby shoring up asset prices.
One of the biggest problems with quantitative easing is that it doesn’t solve the problem of inadequate demand in a sharp downturn. In other words, if a company has the capacity to meet existing and likely future demand – and particularly if they’ve got excess capacity – a low interest rate isn’t sufficient reason to borrow. Conversely, if the lower interest rates extend into the realm of the consumer – as they are now with mortgage rates – it frees up cash for consumers to spend elsewhere.