Mythbusters: Financial Blogger Edition

In Thinking, Fast and SlowDaniel Kahneman introduces the concept of what you see is all there is (WYSIATI). WYSIATI occurs when people jump to conclusions based on limited information. In many aspects of life, rules of thumb can be helpful.

There are times when you need to jump to conclusions based on a small amount of information — like when you’re ordering food at a new restaurant. But there are other times when you need to be more deliberate with your decision-making process — like with your financial moves.

Kahneman lists three areas where WYSIATI can lead to problems in the decision-making process when it leads to:

  1. Overconfidence – Quality of evidence is ignored by our confidence in our own views.
  2. Framing effects – The way information is presented can effect how we perceive it.
  3. Base-rate neglect – When the mind ignores the big picture and focuses on merely on specifics.

A problem many investors face these days is that they’re drawn to headlines. Every expert sounds intelligent to some degree so people take what they say as fact without bothering to question the validity of what they’re saying. The same thing applies to academic research.

One group that has stepped in to bust many of these myths and rules of thumb are financial bloggers. I tend to think bloggers add the most value by giving readers perspective, context and truth to many of the headlines and relied upon narratives people cling to when making investment decisions. There were three alone this week from my fellow bloggers that I want to share.

First up, Meb Faber discusses a commonly held belief about dividend stock investing. Textbooks often teach that a defining characteristic of value stocks is that they pay dividends. Thus many people assume that owning dividend-paying stocks is a form of value investing. The problem is that dividend stocks as a group can become overvalued and not represent a true value. Any asset can become a great buy at one price and a terrible one at another, no matter the yield it’s paying. Here’s Faber on this:

It starts by identifying an investing belief so common, we seldom even think to question it…

All dividends = value

As we’ve been discussing today, that’s not always true. So the first step is simply recognizing that dividends and value – while similar – are unique strategies.

Dividend stocks are often seen as value stocks.  And that has historically been the case. But it’s not always the case.

Keep reading:
What You Don’t Want to Hear About Dividend Stocks (Meb Faber)

One of the more talked about headlines this week in the social finance world came from a story in the New Yorker that asked the question: Is Passive Investment Hurting the Economy? My first thought was this was a ridiculous premise, but many people saw this headline and agreed without thinking through the details. Cullen Roche wrote up a nice rebuttal at Pragmatic Capitalism:

This gets to a more fundamental point about index funds and passive investors in general. A secondary market is little more than the market’s best guess about the future underlying fundamentals of the actual companies. We shouldn’t confuse “the market” with “the economy” and its underlying firms. They are not the same thing and no matter how robotic “the market” becomes it does not mean the market will simply reflect some robotic pricing of the performance of the actual underlying firms in that market.

Keep reading:
Passive Investing Isn’t Hurting the Economy (Prag Cap)

Finally, there are many commonly held beliefs based on historical stock market patterns that investors assume must be true because they’ve shown up in academic research — things like dogs of the dow, sell in may and go away and the January effect. Here’s my colleague Michael Batnick describing the January effect:

In 1976, a group of economists discovered that stocks tended to do well in January, small cap stocks in particular. Small cap stocks returned 26% in January of 1975 and an 18% in January of 1976, enough to get anybody’s attention.  This came to be known as the January effect, and like many other fundamental anomalies, shrunk upon its discovery.

The problem with simple patterns such as these is that once they’re discovered by investors it tends to change how they work or if they work at all. The cycle tends to work like this — first adopters earn high returns from the discovery of an unknown anomaly. Next academic research papers are written. Finally, fund companies and portfolio managers start implementing said anomaly and by the time individual investors show up it’s all but gone.

Keep reading to see how the January effect has held up since its discovery in the 1970s:
The Fool’s Gold (Irrelevant Investor)

And try not to take everything you read or hear at face value.

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Discussions found on the web
  1. Pete Nikolai commented on Mar 12

    “…by the time individual investors show up it’s all but gone.” Such a pattern is sad but true much of the time. However as Souza et al point out in “The Enduring Effect of Time-Series Momentum…” the size effect is strongest in January and can drive substantial losses in cross-sectional momentum strategies that require buying winners (small firms) and shorting losers (extremely small firms).

  2. Minh Tu commented on Mar 13

    The dogs of the dow is just a version of buying stocks out of favor strategy. I learned a long time ago
    with Value Line (now defunct) that buying their lowest rated stock (5) vs their highest rated stock (1)
    is more profitable. Now you have to research each stock before buying anything. Similarly for
    sell side analyst recommendation. “Hold” rated stocks perform better in the long run. Again
    you have to use it as a starting point and do your own research. Don’t just buy indiscriminately.

    • Ben commented on Mar 14

      Agreed. You have to understand how and why things work and not just blindly follow a strategy because it’s worked well in the past.

  3. Marco iachini commented on Mar 17

    Love seeing WYSIATI being mentioned and how overconfidence, framing and base-rate neglect are brought up in your piece. I’m re-reading Kahneman’s book and I couldn’t agree more with him on how these fallacies guide human behavior. It is interesting to notice however how, market anomalies eventually get exploited and dissipate over time while behavioral “anomalies” are neglected and continue to influence investors’ behavior.

    Kahneman mentions how teaching psychology is “pointless” because, although students learn about these fallacies, when they’re tested, their system 2 often remains “lazy” and forgets to access the information stored in their brain (same as with the “outside view” when making forecasts). Just as the students, experts and/or investors often forget to take into consideration their own human limitations and fallacies when making decisions, forecasts or simply discussing general economic issues…

    This is all very fascinating…thanks for sharing

    • Ben commented on Mar 17

      I think that any anomaly needs to have a behavioral reason to explain why it will still exist in the future. No one knows for sure but if we’ve learned anything over the years it’s that changing behavior is not easy for people. Knowledge alone is not enough to change behavior.

      • Marco iachini commented on Mar 17

        Agreed. In fact, according to DK what helps us learn and change our behaviors is personal experience (through surprises); learning about a new statistic or fact won’t stick with us as much, even when we fully understand the implications.

    • Ben commented on Mar 17

      I think that any anomaly needs to have a behavioral reason to explain why it will still exist in the future. No one knows for sure but if we’ve learned anything over the years it’s that changing behavior is not easy for people. Knowledge alone is not enough to change behavior.