Can Behavioral Finance Make You A Better Investor And Improve Your Life?

RichVintage/E+ via Getty ImagesNext week, Seeking Alpha will be holding its first-ever investing summit in New York City! I’m flying in and will be speaking on behavioral finance and economics in an afternoon session with Seeking Alpha editor Max Gottlich. Since I started publishing on finance in 2016, my greatest concentration of readers has always come from the New York metropolitan area. For that, I’m grateful, and I’m looking forward to meeting some of my NYC-based readers in person. Also, my understanding is that we will be uploading the session online later so that all of our worldwide readership can access it. My session is officially titled “Understanding Behavioral Finance When Constructing Portfolios,” but it’s really about how knowing a few simple concepts can make a huge difference in your investing success over time. Decades of research from the US and Western Europe show that investors around the world think in similar patterns, leading to similar asset market inefficiencies. Having an understanding of behavioral finance and behavioral economics will help you to be a better investor. 1. The Quality-Minus Junk Anomaly Think of the last time you went to the grocery store. Let’s say you bought some milk and eggs. You probably grabbed the milk in the front of the shelf– after all, it’s right in front of your face. But what if I told you that grocery stores intentionally load their oldest inventory toward the front of the shelf? They want you to buy the oldest milk possible because that’s how they make the most money. Test this out next time you’re at the grocery store– reach around all the way to the back and grab the dairy, produce, and eggs at the back of the shelf. Check the expiration dates to verify. What you’ll find is that you can get products that are 7-10 days fresher when you do this! 99% of people don’t know this, and it’s probably best for society for consumers to go home with old products before they spoil on the shelf. But you don’t have to settle for 10-day-old milk anymore if you know this little tidbit about behavioral economics. To this point, if your local grocery store is doing this to you, imagine what goes down on Wall Street. There are so many conflicts of interest and embedded middlemen that I’d need to write a whole book to tell you just the ones I know about. However, the biggest anomaly two anomalies aren’t really Wall Street’s fault. In my mind, the top anomaly is probably quality-minus-junk (QMJ). There are plenty of conflicting studies that have been done in the field over the last 40+ years, but I’m selecting a couple of durable anomalies that I think will help you the most as an investor, and QMJ is one of the best. What is quality? In my mind, quality refers to the stocks of companies that have investment-grade credit ratings and turn a profit. Junk is the opposite and contains speculative companies that lose money. The most well-known study on the quality-minus junk anomaly shows that stocks at the 90th percentile or higher on quality return 0.70% per month above the rate of cash, while stocks at the 10th percentile on quality return only 0.28% per month above the rate of cash. The AQR paper uses a fairly complex methodology to rank stocks from the lowest to highest quality, but it captures the gist of the concept quite well. Companies that are profitable and growing tend to perform well, while junky companies with losses and high volatility tend to perform poorly. In the end, the stocks in the quality companies outperform the junky ones by an average of 5-6% annually. Unsurprisingly, the biggest anomaly isn’t in the highest quality stocks, but in avoiding the lowest. This is easy to do– don’t invest in companies that lose tons of money! We can cross-validate this with other studies. A few of the more famous ones: 1. Credit Ratings and The Cross-Section of Stock Returns (Berkeley Haas). Stock returns start to drop off when stocks are rated BB or below, and fall off of a cliff for stocks with credit ratings of B- or lower. The study found that the typical “junk” stock trades for $7 per share, has a low market cap, and has low institutional ownership. 2. “Size Matters, If You Control Your Junk” (AQR). The study found a strong quality minus junk anomaly in small stocks. I confirmed it with my own research via backtests in the second article I wrote for Seeking Alpha in 2018. I found that the S&P 600 (IJR) which has quality control outperformed the Russell 2000 (IWM) by about 200 bps per year. I found that from 2000 to 2018, you’d have made about 2x as much money in IJR as IWM. And since I published the piece in 2018, IJR has outperformed IWM by roughly 100 bps per year. Outperformance is outperformance, but the latent truth of the amount of trash in the Russell 2000 will only be revealed in the next recession. The AQR study shows that much of the outperformance of high-quality companies occurs in recessions when low-quality companies go bankrupt and leave their shareholders with nothing. The Russell 2000 isn’t intentionally designed to invest in junk, but by failing to avoid it, investors are likely losing 200 bps per year or more in the long run. 3. The Capitalism Distribution (Longboard Asset Management). Famous stock market study popularized by Meb Faber. 39% of stocks are unprofitable investments. 19% lose 75% or more of their value. 64% underperform the index. 25% of stocks are responsible for all of the market’s gains. What’s the easiest way to avoid disastrous investments? We’ll cover how to exploit the capitalism distribution in the next section, but the best place to start is to not get involved with investments in money-losing companies in the first place. Screening for quality with ETFs is fairly simple– the S&P 500 (VOO), S&P 400 (IJH), and S&P 600 (IJR) have a built-in quality screen. Use them for your ETF investments, or read the prospectus on dividend-based funds or other ETFs to see if there’s a quality screen. For individual stocks, how do you know if a company is quality or not? Easy. Before buying a stock, simply go to the Seeking Alpha page for the company you’re considering investing in and look at the balance sheet and income statements. It’s not rocket science. Does the company make money? Do assets exceed liabilities? There are a hundred other things you can look at, but it’s really not all that hard to identify a basket case company with a 30-second look at the financials. Key takeaways regarding quality-minus-junk: Try to avoid investing in ETFs that include money-losing companies. Look for quality and avoid junk stocks in your portfolio, using free online tools such as credit ratings and income statements to weed out losers. 2. The Disposition Effect Now that you know about the quality minus junk effect, you might be inclined to take an honest look at your portfolio and think about whether your capital is still working for you in the weakest companies in your portfolio. Research shows that most investors don’t really do this though. One of the most famous behavioral finance anomalies is the so-called “disposition effect,” or the tendency of investors to hold onto losing investments and sell winners. Let’s say you have 100 stocks in your portfolio. It will vary by year and the overall market return, but according to the figures from the capitalism distribution, about a third will be down, a third will be near even, and a third will be up big. Let’s say for round numbers that you have $1,000,000 in your brokerage account and want to buy a new car for $60,000. Where are you getting the money? Most investors will look at their investments and see a big gain somewhere, and sell that to finance their car, down payment on a house, etc. Research shows that this is actually the opposite of what you want to do. From a portfolio performance perspective, you’re actually better off selling some of your worst investments and using that money to buy the car. Why? The winners tend to keep winning, and the losers tend to keep losing on average. By selling your best investments to buy a car, you’re making an intentional or unintentional decision to tilt your portfolio more toward losing stocks. You have to pay taxes on your gain when you do this, but if you have losing investments as well, you might be paying taxes on “income” you don’t really have. The disposition effect is tied to several other well-known finance anomalies such as momentum, post-earnings announcement drift, and loss aversion. It’s not just retail investors that do this– research shows mutual funds managers are nearly as guilty as retail investors, and it partly explains why the industry tends to underperform the market. Conversely, index funds are designed to naturally let winners run while losers are weeded out of the index. That’s the real reason index funds are hard to beat, not that the return of the S&P 500 is some kind of speed limit for how fast you can grow your capital. Should you ever sell stocks that go up? Yes. My personal research has found that the more famous the company you’re investing in is, the less the disposition effect applies. When a stock is quietly up 20%, investors tend to sell it. When a stock is up 200%-plus in a year, it draws in people looking to get rich quick. If everyone is telling you that a stock is a must-own, maybe it isn’t. Long-running research from DFA shows that the top 10 largest stocks in the market have underperformed the index over time after reaching the top. Another limitation of the disposition effect occurs between sectors and asset classes. Just because a certain asset class goes up a lot doesn’t necessarily mean you need to keep loading up. Certain asset classes like fixed income and commodities actually show substantial mean reversion over longer periods of time. So while you certainly want to apply the disposition effect to your single stock holdings, the conventional wisdom around rebalancing your asset allocation is still sound advice. Key takeaways regarding the disposition effect: Winning stocks are often cheaper than they should be (they’ll keep going up). Losing stocks are often more expensive than they should be (they’ll keep going down). You can improve both your tax situation and your portfolio situation if you are slower in selling winners and faster in selling losers. If nothing else, you’ll usually not be wrong by selling a losing position for a tax loss and waiting 31 days to buy it back so you can book the loss for tax purposes. If you’re selling stock to fund personal purchases, at least try to sell proportionately to what you own rather than putting winners on the chopping block. Other Useful Behavioral Economics Points 1. American consumers are really bad at earning interest on their money. Banks essentially serve as middlemen and make billions in profit on the spread between what they pay in deposits and what they earn by investing in Treasuries. High-yield savings accounts are gaining popularity, but you can do better. It’s simple to cut out the middleman and go for a money market mutual fund. I prefer Vanguard’s default money market fund (VMFXX). We can infer from deposit data that consumers are leaving hundreds of billions per year on the table each year here. One survey showed that 93% of consumers are earning 4% or less on their savings, with over half earning less than 1%. This is thousands of dollars per year, and people either don’t know or are too lazy to pick up the free money. 2. US consumers also are unwittingly subsidizing a system where credit card companies earn roughly 3% fees on transactions and rebate savvy consumers the majority of the money. If you aren’t playing any cash-back games on your credit cards, pennies from every transaction you make are effectively going to consumers who are. If you haven’t already, you can earn thousands of dollars in signup bonuses for various bank credit cards without even getting out of bed. And then once the cards are open, it’s pretty simple to optimize your spending to generate thousands per year in cash back. Over half of consumers are using debit cards for most transactions. Points 1 and 2 combine here to create a fairly large wealth transfer between people who understand the financial system and those who don’t. I see this frequently with people who make good salaries and complain their money doesn’t go very far. 3. You can save 5-10% on leasing or buying real estate if you do so in winter. Demand for housing is highest in summer, leading to higher prices for consumers. Timing a lease or going house hunting in the winter is something that consumers rarely do, but everything from mortgages to moving companies to rent is cheaper in winter. I get that parents are averse to moving kids during the school year, but they see the explicit cost but fail to understand the implicit costs, which are surprisingly large. 4. Commuting is surprisingly expensive, especially by car. People dramatically underestimate how much they spend on commuting, especially if both spouses work. For 2024, figure about 63 cents per mile, and multiply by the number of days you and your partner go to work. It gets worse because commuting is paid for with after-tax dollars. Sometimes this is a $25,000 per year line item, and it’s an overlooked cost because it’s implicit. 5. For New York and New Jersey residents (and other states where sports betting is legal with a sufficient amount of competition), sportsbooks are giving silly amounts of bonuses to those willing to sign up. Anyone with stock market experience can exploit the large and diverse sports betting markets for both signup bonuses and arbitrage opportunities. Ask me about this in the Q&A after my session for more. Bottom Line Knowing behavioral finance and economics will lead you to all kinds of hidden gems that will help increase your wealth. Understanding anomalies like quality-minus-junk and the disposition effect will help you manage your portfolio better. Additionally, knowing practical applications of economics will help make your life more prosperous, less stressful, and more fun.

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