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By Jason Stipp | 10-17-2011 01:36 PM

Dorsey: Rewire Your Brain for Better Investing

Overcoming mental roadblocks like loss aversion, the endowment effect, and recency bias can have a profound effect on investors' returns, says Sanibel Captiva's Pat Dorsey.

Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar's 5 Days to Better Investing, today we're talking about behavioral finance and how you can actually behave better and improve your chance for better returns.

Joining me today to talk about some behavioral finance issues is Sanibel Captiva Trust's, Pat Dorsey. He is their director of research, and a former director of equity research here at Morningstar.

He is going to give us some tips to overcome some of those stumbling blocks.

Thanks for joining me, Pat.

Pat Dorsey: Always happy to be here, Jason.

Stipp: So behavioral finance, it seems to me that if you did overcome some of these mental areas, you might able to improve things on the margin, but the fact is that the way that you behave, your temperament, actually has a much bigger potential impact on your returns.

Dorsey: It's absolutely huge. There's a Buffett quote that I always love, which says that once you go from 130 to 160 IQ, it really doesn't matter. What gets people into trouble in investing is their temperament, making the wrong decisions, not being smarter or less smart.

Stipp: So as a smaller investor, this is one of those things you actually can control and you actually can have a pretty big impact on your returns.

Dorsey: Especially because, as a smaller investor, you don't suffer from something that most portfolio managers do, which is called career risk. If you're a portfolio manager, at your average large mutual fund shop, your performance versus the benchmark and your peers is being tracked week by week. You underperform for a couple of weeks, or you have a rough quarter, your boss is going to come around and say, "You know, Jason, I think it was those stocks--ACME or whatever else--that you bought, and they're not doing so well."

And so you go, "Ugh! If I keep owning those, I might lose my job," and that's a huge issue for you. Whereas, of course, if you are an individual investor, you can't fire yourself. You have no career risk in that sense. So, hopefully, you can think a little more rationally.

Stipp: So thinking a little bit more rationally, this is a way for you as an individual to potentially get ahead, but it doesn't mean that it's easy. These are the things that are difficult to overcome.

So, I'd like to talk about some of these mental roadblocks that we encounter, and specifically, I'd like to start with what's known as "loss aversion" because this is something that's probably on a lot of investors' minds recently. So, what is this exactly and how can you overcome it?

Dorsey: What it boils down to--and this is really one of the original findings in behavioral economics that we're not the rational utility maximizers that the economists would think we are--is that losses hurt us two times more than gains give us pleasure--two times more than gains give us pleasure.

And the outcome of this is that people are unwilling to convert in investing an unrealized loss into a realized loss. Hanging on to your losers and just sort of watching them go down, go down, go down, hoping they bounce back a little bit so you'll sell them. I think that's something a lot of investors can sympathize with. And it's not because we are stupid or weird; that's how our brains are wired. It's hard for us to lose money. It's hard to say, "Well, I am down 10% on this, but I was wrong. My investment thesis was just flat wrong. So, I am going to take my loss and move on to the next investment." It's very, very difficult to do, but it's one of the reasons why people tend to hold on to their losers way, way too long.

Stipp: So, how can you overcome this, because you don't necessarily want to lock in a loss if you think that the security has a brighter future, but how do you make sure that you are cutting something of loose when you need to cut it lose? What's the mental exercise you need to go through?

Dorsey: The mental exercise is look into the future and not the past--which is a lot harder than it sounds, of course. The market doesn't care whether you have a gain or a loss. The security doesn't care if you have a gain or a loss. The security doesn't know. All that matters is what will that company earn in the future, or how will that mutual fund manager invest your assets in the future. What they have done recently is close to irrelevant.

So that's what you need to be thinking about going forward. If you have a loss in it, but your original investment thesis was sound. If the manager is still executing on their process. You stand pat. But if you have a loss and the competitive situation has heated up for the company or the manager has gotten fired or kind of gone off the rails, which mutual fund managers do once in a while, well then the future has changed; but it's the future that's changed. It has nothing to do with what the securities' returns have been in the past.

Stipp: Another mental roadblock that can cause investors to hold onto something too long is known as "endowment effect." What exactly is that and how does that affect investors?

Dorsey: This is a great one. So, we overvalue what we already own. I actually gave a talk on behavioral finance just this past Friday in Omaha, The University of Nebraska at Omaha, and I did an exercise where basically I asked students, what would they pay for a coffee mug, and then I asked another group of students, I gave them the mug and said, what would you sell this back to me? It's the exact same mug. Two times was the difference. So, basically, people would only pay $3 for the mug, but if I gave them the mug and asked them to sell it back to me, it took about $6-$7. So, that's insane because it's the same mug, right?

And so the outcome of this in investing is that people tend to get very ... have you've ever heard "falling in love with your stocks?" Maybe you have a security that has a low cost basis, it's done well for you over many years, and then it kind of starts to roll over, and roll over, and roll over, and roll over, and you're reluctant to let it go. It's because you're not evaluating securities on a level playing field.

And that is how you tackle this, is you always tackle securities on a level playing field, whether you own the fund or don't own the fund, own the stock or don't own the stock--it's not relevant. All that matters is, how will it perform in the future? So, again, it's very hard to do, but focusing on "this manager has made me lots of money" or "this stock has gone up a lot in the past six or seven years." Those are not relevant pieces of data.

Stipp: So, it's not only how well will it do in the future, but how well will it do in the future compared to what your other options may be as well?

Dorsey: Exactly right, exactly right. So, certainly, it could be that I think this stock will continue to grow earnings at a 3%-4% rate, but maybe the market is taking a giant header. Maybe China just fell by 50% and Chinese stocks are on sale, you're going to get a much better growth rate there at similar valuations. So, evaluating other alternatives always makes sense.

Stipp: So, Pat, another thing that can hold me up is the fact that I like to be liked, and this is related to something called social proof. What is that?

Dorsey: Basically, it's just that--that humans are wired to be social animals. You go back to the savannah where we kind of evolved, and, you know, being in a band of six was probably more likely to help you survive than being one guy who couldn't get along with anybody. So we're wired that way for survival purposes.

But in investing, it can get you into a lot of trouble, because just because the crowd is doing something doesn't mean it's right. It doesn't means it's wrong, either, but certainly doesn't mean it's right.

And frankly, the financial media can reinforce this, because what sells magazine and ads on CNBC is what's popular right now. So the media tends to talk about what's in favor, not what's not in favor.

And so, the way to tackle this as an investor, to try to get around this, is just to bear in mind that just because everybody else is doing it, everybody is talking about it, doesn't mean it's the right decision. In fact, again it's not relevant. Whether your buddy is buying the stock or whether there is lots and lots of stories about a particular asset class in the paper, it's simply not relevant to whether that asset class or that fund or that stock will do well in the future.

Stipp: So it doesn't mean that the crowd is wrong necessarily, but it doesn't mean that they are right necessarily?

Dorsey: Exactly. You don't want to be a knee-jerk contrarian. I mean, look at what happened to knee-jerk contrarians like David Dreman, for example, in late '08 with the banking stocks. They didn't recognize that it was different that time. There had been a huge shift in the mortgage marketplace that was going to cause losses to be worse than they'd ever been in the past.

In that case, just blindly running in the opposite direction of the crowd didn't do you any good. Again, it's not that what the crowd thinks, you should always be running in the opposite direction. It's that what other people think is irrelevant. It's your money. It's the stock you own. It's a fund that you own. What people on CNBC think about it, what a writer at Fortune magazine thinks about it, what your brother-in-law thinks about it. It's not relevant.

Stipp: So Pat, another thing that has come up, and I think this is another timely one, is the fact that we've seen not only in 2008 that horrible market downturn, but also a lot of rockiness again in the late summer and early fall here that creates the sense of things are going down again. They are going to keep going down. That's what we've been seeing. This is related to something called recency bias. How does that play out and how can you overcome that?

Dorsey: People tend to overweight the most recent information. So, of course, in 2007 home prices weren't go up forever. In 2009, we were talking about, Dow 2000 and things like that. So this has been demonstrated empirically, actually, with sell-side analyst estimates, which consistently lag actual earnings, lag by 9 to 12 months. Typically sell-side consensus earnings turn most bullish right as actual earnings roll over, and they turn most bearish right as earnings recover. That's because they're overweighting the most recent information.

And the way to get around this as an investor is to just look over the long span of time, just look at average earnings growth for corporate America, it has been 5%-6% over a long span of time. That's kind of the relevant number, much more so than "were earnings down 15% last year or up 20% last year."

So, looking at lots of data over long spans of time, asset class returns, something that I think Jack Bogle has always spoken a lot about. Looking at what asset classes, equities, bonds, what have you, had done over long spans of time is a much better guide to your future experience than what's happened in the past year.

Stipp: Last one, Pat. We talked about how, as humans, we like to be liked, but as humans we also like to be right. So I think we go out and tend to try to find things that will support our argument. This can lead to something that's known as a confirmation bias. How do you overcome this?

Dorsey: We process information that we already agree with more easily. Most Democrats don't hang out with people with Sarah Palin bumper stickers. Most Republicans don't have a GObama sticker on their car. We hang out with people who think like us. And in investing, that means if you feel good about the market, you probably read a bullish investor, right. If you thought Treasuries were a terrible investment, you're probably saying, "Go Bill Gross!" over the past year. That didn't work out so well. It turned out that people on the other side of that trade were more right.

So what you need to do, then, is you literally need to read about points of view, listen to individuals, consciously seek them out, who make your tummy ache. They make you feel bad, because they're disagreeing with you, and frankly their point of view says, you might be wrong. But that is really valuable information to know.

You kind of go back to the ... Ronald Reagan "Trust, but verify," it's kind of like. That trust your own opinions, but verify them. Verify them by actively seeking out people with the other point of view, and then testing your own beliefs. You might wind up saying well, "I'm still right," or you might come across information you wouldn't have otherwise found that will help you make a better decision.

Stipp: Well, Pat, it doesn't sound like it's easy to overcome a lot of these mental roadblocks, but certainly it sounds like it could pay off for you in the long run. Thanks for joining me.

Dorsey: Thanks so much for having me, Jason.

Jason Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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