by FPA member David Zuckerman, CFP®, CIMA®
When was the last time that you were surprised by your investment portfolio? Was the surprise a positive or negative one? If you are like most people, you will remember negative surprises much better.
Behavioral finance blends the fields of psychology and economics to provide valuable insight into this phenomenon. While traditional economics holds that people act rationally, behavioral finance examines the forces that drive irrational decisions.
Negative Surprises Sting More than Positive Surprises Please
Consider a study where participants had to identify the odd letter in a string of letters as soon as possible (e.g. the W in TTTTTWTT). If a mistake was made, the participant would face one of three outcomes: gain money, lose money, or no financial consequence. When a mistake resulted in financial loss, the anterior cingulated cortex (ACC) showed much more intense activity than when there were no financial consequences. The brainstem, the area of the brain located above the spinal cord that regulates basic bodily functions, also responded to monetary loss. But without financial consequences the brainstem barely responded at all.
In another study, researchers used tiny electrodes to monitor neuron activity in the ACC while participants moved a joystick to earn cash rewards. The study revealed that 38% of the neurons fired when the reward money shrank, but only 13 percent of the neurons fired when the gain was larger than expected. Such evidence exemplifies the fact that the human brain responds much more dramatically to negative surprises. Accordingly, it should not be a surprise that stocks which beat Wall Street’s earnings expectations gain an average of 1 percent, while stocks that fall short of expectations decline by an average of 3.4 percent.
In an evolutionary context, these responses make sense. Early man’s survival was aided by our brain’s ability to recognize mistakes fast. In the world of investing, however, allowing a minor surprise to cause a major shift in your portfolio can result in unfavorable outcomes. So what can you do to avoid knee-jerk responses that lead to unjustified shifts in your investment strategy?
Expect the Unexpected
Our predictions of the future will often be wrong; and the more certain we feel about our predictions, the bigger the surprise will be. Learn to expect the unexpected.
Too often investors support investment decisions with information that is widely disseminated. Have you ever heard someone say that a company will make a good investment because “everybody knows” the company and uses their products? The reality, however, is that what “everybody knows” is probably already reflected in the stock price. And if it turns out that what “everybody knows” is not consistent with future results, then a big negative surprise can result.
Try not to look for investment opportunities that are based on popular opinion, as popular investments often lead to unpopular outcomes. “Glamorous” stocks often captivate the public’s attention simply because of their rapid growth. But rapid growth brings with it high expectations that are often reflected in share prices of these growth stocks. For many of these stocks, positive surprises will have little effect on their price, while even a small, negative surprise can send their prices tumbling. Consider an earnings miss (reported earnings less than consensus estimates) of as little as three cents. A growth company will, on average, see share prices drop two to three times farther than a value company with an earnings miss of similar magnitude. Value stocks, on the other hand, often reflect expectations so low that a negative surprise will not hurt as much. And a positive surprise for a value stock with low expectations can send the price surging higher.
Understand Why You are Surprised
As you experience more surprises, you will be less affected by them. Try to learn from surprises: use an “investment diary” to record your feelings and reactions to surprises; and make sure to record what made the surprise so unexpected.
Next, look beyond the surprise itself. Focus both on what caused the surprise and how your view of the company may have changed as a result of the surprise.1 Have a company’s fundamentals changed so dramatically that your fair value estimate for its shares needs to be revised? Years from now, will you look back on this surprise and see it as causing a fundamental, paradigm shift for your investment? Or will you look back on the surprise and wonder what all the fuss was about?
You can also mitigate surprises by simply knowing more about the company that you are investing in. Have you read the annual 10-K shareholder report that companies are required to file? These reports provide a lot of information beyond the basic financial statements of a company - such as information about primary competitors, significant risk factors, and changes in the company’s organization or business strategy. Unless you choose to rely on an experienced fund manager, these are things that the prudent investor should know in order to better understand a company and avoid surprises. For example, although you may be impressed to read that a company increased its dividends or bought back some of its own stock, you may be less impressed if you were to learn that the company financed this with increased borrowing - in which case you would also be much less surprised if its share price does not experience a sustained, long-term increase from this "positive" news.
The human brain has evolved to recognize and react quickly to negative surprises. But when surprises lead investors to overreact to bad news, returns can suffer. If you need help deciphering between bad results that meaningfully affect fundamentals and surprises that lead to overreactions, consider consulting a CERTIFIED FINANCIAL PLANNERTM professional from FPA with the experience and expertise necessary to guide you.
1Jason Zweig, Your Money & Your Brain (Simon & Schuster, 2007), 176-189
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.