Investing Guide

Investors have multiple accounts to minimize, delay and avoid taxation. Assets are taxed when a capital gain is realized or when income is received through coupon payments or dividends. Taxes can be delayed with a Traditional IRA, 401k or 403B plan. Taxes can be avoided by using a ROTH IRA or ROTH 401k. Some life insurance and municipal bonds can shelter asset returns. Trusts can be used to minimize or avoid the taxation related to transfer of wealth to heirs. Public and private foundations are also used to transfer wealth to charities.

Asset locations strategy is to place the most tax inefficient assets in the tax deferred/free accounts and the most tax efficient assets in the taxable accounts. The general rule of thumb is to place tax inefficient assets such as bonds, value stocks, and mutual funds with high distributions into tax deferred accounts.  Stocks, index funds, and municipal bonds should be placed in taxable accounts because of the tax efficiency.

Investors who view familiar stocks as better investments (higher return, lower risk) than unfamiliar ones.  Investors tend to invest in investments that they are familiar with such as their own company stocks.  They are also more comfortable investing in companies closer to home such as domestic stocks instead of foreign companies. 

Investors affected by familiarity tend to feel comfortable investing in stocks they are familiar with even though they have not done any thorough research on the company.  The feel the company will perform well even though they have a false sense of familiarity because they have not done their due diligence.  Since they do not take in to account the risk associated with the investment, it will lead them to concentrated undiversified positions.

Decisions are affected by the particular framework a person is in. Purely economic decision are made when a person act with frame independence.  Some of the behavioral characteristics that can be attributed to frame dependence include loss aversion, self-control, regret minimization, and money illusion.

Loss Aversion

Loss aversion is an investor’s reluctance to accept a loss.  The tend to hold onto losers hoping to break even. Loss aversion leads to increase risk seeking behavior. People may invest in riskier securities to try to recoup losses.

Self Control

Self Control has to do with emotions.  Investors may use a self control mechanism to control their actions.  One example that retired people use is to only spend interest and dividend payments to prevent themselves from spending down principal too quickly.

Regret Minimization

Investors will try to prevent making a bad decision.  They will invest in familiar investments such as stocks, bonds and mutual funds.  Instead of selling securities, they would rather spend their cash flow such as dividend and interest payments.

Money Illusion

People think of performance in nominal terms.  They do not account for inflation in determining their real returns.

These are the frame dependent behaviors typical investors exhibit.

People often develop investment decisions using a heuristic learning process.  Heuristic learning process uses personal experience, trial and error and experimentation to develop investment rules.  The four steps according to Shefrin are:

1.  People develop general principles as they learn about it themselves.

2.  They rely on heuristics to draw inferences from information.

3.  The heuristic used is imperfect making them more likely to make mistakes.

4.  Commit error in particular situations.

Some common heuristics are representativeness, overconfidence, achor and adjustment and aversion to ambiguity.

Representativeness

Representativeness is a heuristic process in which investors base expectations on past experience.  One example would be an investor who thinks that a stock would perform well because it has done so in the past few years without doing research to back up their expectation.   This heuristic happens when investors base future expectations on past or current condition.

Overconfidence

Many investors are overconfident of their forecasting abilities.  This includes experts as well as individual investors.  One study done in 2006 called Behaving Badly done by James Montier shows that 74% of 300 fund managers believed they delivered above average performance.  The remaining 26% viewed themselves as average.  Only 50% of the group can be above average, which shows the high level of overconfidence in fund managers.  Overconfidence also occurs with individual investors too.  Overconfident investor conduct more trades than the normal investor, but their returns are below average. 

Achoring and Adjustment

Achoring and Adjustment is the inability to fully incorporate new information into forecasts.  People achor to their previous number and the new information does not have a big of an impact as it should. 

Here is a diamond achor I saw from Investopedia:

“Consider this classic example: Conventional wisdom dictates that a diamond engagement ring should cost around two months’ worth of salary. Believe it or not, this “standard” is one of the most illogical examples of anchoring. While spending two months worth of salary can serve as a benchmark, it is a completely irrelevant reference point created by the jewelry industry to maximize profits, and not a valuation of love.Many men can’t afford to devote two months of salary towards a ring while paying for living expenses. Consequently, many go into debt in order to meet the “standard”. In many cases, the “diamond anchor” will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt.

Although the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two-month standard. Because buying jewelry is a “novel” experience for many men, they are more likely to purchase something that is around the “standard”, despite the expense. This is the power of anchoring. ”

Achoring can occur randomly too.  People will achor to random numbers. 

“In a 1974 paper entitled “Judgment Under Uncertainty: Heuristics And Biases”, Kahneman and Tversky conducted a study in which a wheel containing the numbers 1 though 100 was spun. Then, subjects were asked whether the percentage of U.N. membership accounted for by African countries was higher or lower than the number on the wheel. Afterward, the subjects were asked to give an actual estimate. Tversky and Kahneman found that the seemingly random anchoring value of the number on which the wheel landed had a pronounced effect on the answer that the subjects gave. For example, when the wheel landed on 10, the average estimate given by the subjects was 25%, whereas when the wheel landed on 60, the average estimate was 45%. As you can see, the random number had an anchoring effect on the subjects’ responses, pulling their estimates closer to the number they were just shown - even though the number had absolutely no correlation at all to the question.”

One example of investment anchoring that I do is buying stocks that drop a lot from their 52-weeks high.  I anchor on a the 52 week high believing even though I am unsure if the fundamentals have changed. 

Aversion to Ambiguity

People prefer certainty to uncertainty.  They will try to avoid the unknown.  A good example of aversion to ambiguity is momentum investing.  Momentum investors prefer prefer to buy stocks on an uptrend because they believe they have a greater than 50% chance of making money.  In a non-trending market, momentum investors stay on the sidelines because they are unsure of the direction of the market. 

These are the common heuristics people use in investing as well as everyday life.