The hot-handed gambler
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 8 October 2016.
Imagine you are a finalist at the World Championship of Coin Tossing. Your goal is not to toss the coin higher or further than anyone else; rather, you just need to correctly guess what the result of the next coin toss will be. The rules of the game are reasonably simple: the coin gets tossed five times and you need to correctly call the sixth toss. If you get it wrong, your only solace is a Mad Monday celebration with the other losers. Get it right however, and you get to stay awake partying for five days straight and even appear on the national news, complete with the obligatory sunglasses and husky voice. Or something like that. Anyway, back to the action. The coin gets tossed five times and amazingly comes up heads five times in a row. Your entire coin-toss calling career now depends on correctly calling the next toss; what’s it going to be? Heads or Tails? Given that the coin has landed heads side up five times in a row, you may be thinking that the next toss is more likely to be a tail than a head, right? Wrong, it’s still a 50:50 call. The fact that the coin has landed on a head the previous five times is completely irrelevant to the potential outcome of the next toss. The coin has no idea it just landed on heads five times in a row – the outcome of the next toss is always going to be 50:50 between a head or a tail. Even if the coin landed on heads 100 times in a row the probability of the next toss being a tail is still no more than 50%.
Welcome to The Gambler’s Fallacy. Not the latest release by Kenny Rogers, but rather, a behavioural trait in humans where we expect a sequence of random events to have an influence on the outcome of the next random event in the sequence. Keen followers of roulette are particularly prone to The Gambler’s Fallacy, erroneously believing that certain numbers are more likely to come up than others, or that patterns can be discerned in what are only random events. Related to this is the Hot Hand Fallacy. Not a Nick Cave single, but the incorrect belief that streaks of ‘luck’ can be divined in what are essentially random events. By now, you’re probably asking yourself, what’s the link to finance? Well, in essence, short term movements in share prices are effectively random events, but that doesn’t stop people from trying to discern patterns where none exist. The truth is, short term share trading is nothing but guesswork. In the longer term, company fundamentals such as revenue and profits are the true drivers. My advice: forget the gambling and focus on the fundamentals.
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 24 September 2016.
In just under a week’s time we’re moving house, an event I’m not looking forward to with any great enthusiasm. According to reports, based on the levels of stress generated, moving house is up there with poking your eye out with your thumb or cutting off your arm with a jigsaw. Ok maybe that’s not entirely true, but it sure feels like it. Mind you, it has been over five years since our last move, so the pain and horror associated with that event has at least been partly dulled by the passage of time. On that occasion we foolishly decided to move ourselves, after all how hard could it be? Well it was incredibly hard. Maybe not fighting-a-rear-guard-action-along-the-Kokoda-Track hard, but certainly I’m-not-sure-my-back-will-ever-be-the-same-again hard. Really, why else do removal companies exist, if it was that easy to pack up a house and move it from one spot to another? Technically we all could do it ourselves, but does that mean we should?
Moving house, as with most things in life, is best left to the people who do it for a living. Sure you don’t need a post-graduate qualification to get a job at a removals firm, but someone who has packed a truck two hundred times and has the back and muscles for it, is probably going to do it a lot better and more easily than you. The same principle applies to investing and managing your finances. There’s nothing to stop you from managing your own investments or looking after your own superannuation. Many people do, and they do it well, but they either love doing it and would happily stare at a stock price chart all day, or they have put in the hours and hours of necessary reading, research and planning to allow them to make informed decisions. If your idea of the perfect retirement involves checking share prices every hour and thinking about the correlation between changes in interest rates in the US and household spending patterns in Australia, then by all means do it yourself. For most people however, that scenario is more akin to a stint in hell than the relaxing trouble-free retirement they’ve spent 40 years working towards. That’s not to say that the professionals never get it wrong, of course they do, just like when the removalist packs your gym weights on top of your glass vase. However, the consequences are usually and hopefully less destructive when they do. So next week we’ll be paying the professionals to move while I focus on markets and the economy. Let them do their job and I’ll get on with mine.
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 10 September 2017.
Before I became a parent I had very little knowledge or experience of small people. I knew they came with sleepless nights and a much-reduced bank balance for example, but that was about as far as my familiarity stretched. I had no idea, for instance, that they are incredibly easy to fool. My current favourite trick to play on the kids is to move their toys around when they’re asleep at night. In the morning, they might inexplicably find Kate’s ballerina Barbie doll hanging off a ceiling light fitting, along with one of Jack’s Star Wars figurines. Or Jack’s teddy, Jerry the Giraffe, might be found having a tea party with Kate’s Pooh Bear on top of the lounge curtain rail. It always prompts much conjecture about how they got there (did they fly?), what they’re doing and how they’re going to get down. Sometimes I’ll forget to move the toys on to a new location, sparking much speculation about whether they’re asleep or why they haven’t moved for a week. This serves as a timely prompt for me to relocate the toys to a more exotic spot – hanging precariously from the smoke alarm for instance. When the toys get spotted in their new location, we’re eagerly summonsed to come and view this startling finding for ourselves. I always shake my head in wonderment and solemnly proclaim it must be magic. This unbelievable revelation is, of course, accepted without question. From Jack and Kate’s perspective, we must surely have one of the most magical houses in the world.
Unfortunately, when it comes to investing and managing your finances, there is no magic. There’s no fairy dust to sprinkle over your investments; no ‘secret sauce’ to making money; no conjuring tricks to grow your bank balance overnight. Sometimes people think that they must be missing out on something; that there’s some easy step to making money which they just haven’t yet heard about. I have bad news for those people – there’s no such thing. And don’t mistake complexity for magic: in my experience more complexity usually means greater costs, not greater returns. Just because you can’t understand how an investment works, doesn’t mean it’s magical, in fact it’s more likely to be improbable. There really are no shortcuts to wealth, short of winning the lottery, and for most people the odds of that happening are about as likely as catching sight of Jack and Kate’s toys as they fly from one picnic spot to another each night
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 27 August 2016.
Our eldest son, Jack, recently started playing soccer for the Red Pandas Under 6 team. Jack doesn’t know it yet of course, but this is all part of my plan for him to turn professional, play for a top-ranked European club and earn millions of dollars, all so his parents can retire young and in style. My wife thinks it’s about making friends and having a good time. How naive! As you would expect at this age however, skill levels are pretty low. There’s just a knot of bodies pushing, shouting and aimlessly kicking each other without any real discernible purpose. And that’s just the mums and dads on the sidelines – on the field it’s even worse. Half the time the kids have forgotten in which direction they’re playing, with own goals a regular occurrence, although they’re still celebrated with the same exuberance as a normal goal. Sometimes a team member will simply decide that he or she doesn’t want to play anymore, just like in real life, only without the fake injury, although the forced tears and histrionics are apparently a feature at both the Under 6’s and professional level. Eventually however, a bunch of aimless kicks ultimately leads to the ball ricocheting off a knee, head and bum and into the back of the net and everyone cheers and goes home happy.
Unfortunately for some people, their approach to managing their finances is about as organised as two teams of five-year olds on a soccer pitch. The lack of structure is the same: put some money here; buy this property; invest in this share; open that superannuation account; sign up for this credit card….a bunch of seemingly random decisions, made in the faint hope that out of the chaos a goal gets scored, money gets made and everyone gets to retire happy. In reality, the chances of that happening are about as likely as Jack scoring a goal on purpose, and in the right direction. Just like a winning team never takes to the field without a plan and a strategy, so should you have a documented approach to your finances. Will you favour superannuation over your mortgage? Should you salary sacrifice or focus on paying off your non-deductible debt? Is money in the bank appropriate for your goals and objectives, or would a diversified share portfolio suit you better? Only around 1 in 10 Australians use the help of a financial adviser in drafting and implementing a financial strategy. For the other 9 out of 10 people out there, a comfortable financial future is sadly about as unlikely as Jack making the team at Manchester United.
Have a seat
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 13 August 2016.
In our office we all have standing desks. They’re a special type of desk which allows you to raise the height of your keyboard and monitor such that you can be standing while working. The principle is well-established: prolonged sitting is bad for you and you can add years to your life by getting up on your feet. A scary article recently claimed that more than four hours per day of screen time, a figure that the average office worker would easily eclipse, increases your risk of death by any cause by 50%! Inspired (or rather, unnerved) by this, the decision was made to buy everyone in the office one of the fancy desks. It’s all about squeezing in a little bit more motion and activity into the day. Rather than sit down for 8 hours, spend some of that time standing and in doing so burn a few extra calories and hopefully prolong your life. If you have to be at work for eight hours a day, you may as well use the time to reduce your chances of dying.
While it is commonly accepted that being active and moving around is good for your health, the same doesn’t necessarily apply to your investments. Many people operate under the misconception that your assets have to be ‘worked’. That is, you’ve got to be getting in there, buying and selling, chopping and changing and generally messing around with your investments as much as possible. If you own shares, you’ve got to be trading as much as possible; if you have managed funds or superannuation you have to try to chase the best fund managers and keep selling the others. The truth is, all this activity is more than likely hurting your wealth, not helping to grow it. Take shares for instance. A share is exactly what its name suggests – a share in a business. Yes, you might only own a really small share of that business, but you are still a part-owner. It’s the ownership aspect of shares that people often forget. The objective is to take a stake in a business (however small that stake is) and see the value of your investment grow over time as the business grows. The fact that someone is willing to buy your shares off you for 3% more than you paid for them only one day ago has no bearing on the performance of the company. To paraphrase the world’s most successful investor, Warren Buffett, every investment you make should be with the intent to hold it forever, though of course circumstances can change over time. So next time you are thinking of meddling with your investments, don’t just do something, sit there!
It’s my mug
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 30 July 2016.
People are becoming increasingly aware that our emotions and psychological biases play an important role in how we approach investment decisions. The relatively new field of behavioural finance attempts to explain how these biases influence our actions and decisions, usually for the worse unfortunately. Instead of being calm and rational when confronted with complex decisions regarding risk and return, we instead tend to let our base instincts and emotions take over. The end result is generally an unpleasant one from a financial perspective.
One of my favourite psychological biases is called the endowment effect. This is one which most people can relate to and is simple to understand. The endowment effect was illustrated by an experiment conducted by three researchers, Kahneman, Knetsch and Thaler, in 1990. In the experiment a number of volunteers were divided into two groups. The first group were given a coffee mug and told it was theirs to keep. They were then asked what price they would accept to sell the mug. The second group of volunteers weren’t given the mug, but were shown the same mug and asked what price they would offer to buy the mug. As you might expect, the first group who ‘owned’ the mug expected an offer to buy the mug that was on average much higher than the price the second group, who didn’t have a mug, thought was a reasonable price for the mug. Remember, this is the same mug, with a random bunch of volunteers. The only difference was that the first group, the owners of the mug, felt that it was worth much more simply because they owned it. In essence, value is ‘endowed’ on the mug (hence its name, the endowment effect) simply through the act of ownership.
The endowment effect translates very easily to the stock market. If I owned Telstra shares, for example, the endowment effect suggests that I’m likely to think they’re worth more than they really are, or the price that buyers are prepared to pay for them. So instead of selling at an appropriate price, I’m likely to hang on, waiting for my unrealistic price to be reached, which may never happen. And so another bad investment decision gets added to the tally. The emotional feelings associated with ownership have outweighed the rational decision-making process we all like to think we follow. If this has happened to you, don’t feel too bad, you wouldn’t be the first and certainly won’t be the last to feel like a mug.
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 16 July 2016.
One of the unheralded wonders of the modern world has to be the humble asterisk. You know, this one ‘*’. When you start looking for it, you find it everywhere. Mobile plan and insurance advertisements on television; advertising billboards on the side of the highway; even politician’s promises. Ok I made that last one up, but if there was ever a worthy place for an asterisk it would be at the end of every sentence ever uttered by a politician. Examples include the following: “There will be no carbon tax under the government I lead*” and “…no cuts to education, no cuts to health, no changes to pensions*”. See how much better those sentences read if you include an asterisk? The asterisk immediately alerts you to the fact that what you’ve just read is subject to a bunch of caveats and conditions which essentially render the promise or commitment worthless. No side of politics or politician is blameless in asterisk abuse either; mastery of the asterisk appears to be a mandatory skill for acceptance into parliament.
Unfortunately the finance industry is also prone to asterisk abuse. The industry is fertile ground for making grand statements subject to a bewildering range of conditions. “Earn a guaranteed return of 19%!*” is the type of statement that you frequently see in investment advertising. The asterisk, of course, will tell you that the term ‘guaranteed’ only applies to the timing of the payments, such as, ‘we guarantee to pay you on the 15th of the month, but we make no guarantee that there will be any money to actually pay you’. Another common statement might be “Our growth investment option earned 15% last year*”, where the asterisk tells you that such a return assumes no fees, no taxes, that you invested at the market lows and sold out at the market highs and won the Second Division Powerball lottery and added the winnings to your investment. Seldom can so much be said by just one alphanumeric character, as when you wield the power of the asterisk.
Asterisks cannot be defeated of course, they can only be understood. The presence of an asterisk should be a blaring, flashing, vibrating warning light that you are at risk of being duped. This risk can only be managed by reading the nearly invisible small print which accompanies every asterisk. This is where the truth lies. Where you find out about the fees, costs, impossibilities and improbabilities of the headline statement. Don’t ignore the asterisk, it’s not your friend!*
*Unless of course you want to be a politician
Use the Force, Jack!
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 2 July 2016.
Our kids have recently discovered Star Wars and now spend their days whacking each other on the head with their light sabres while yelling out ‘Use the Force Luke!’ and ‘Feel the Power of the Dark Side!’ I probably didn’t help their Star Wars obsession by buying them each a Stormtrooper mask. It’s quite something when a Stormtrooper wakes you up at 4 in the morning, wielding a flashing light sabre and yelling ‘Daddy I’ve got to do a wee!’ As you would expect of one of the greatest movie stories of all time, Star Wars has a number of investment lessons for prospective investors (and no, mastery of the Force is not going to allow you to know which shares are going to go up before they actually do – I believe that’s part of the Dark Side, is also known as insider trading and comes with a spell at Long Bay Jail).
The first Star Wars investment lesson is this: just like Yoda, great things can come in small sizes. Don’t ignore a company just because it’s small; all big companies started out as small ones. Investing in smaller companies can provide a significant element of growth to your portfolio. Of course, just like Yoda tended to speak in riddles and was maddeningly difficult to understand, small companies can be difficult to accurately assess and value. What price do you put on a two-week old company run by two uni drop-outs from their garage? Sometimes nothing, sometimes it turns out as valuable as Apple or Microsoft. The second Star Wars investment lesson comes from Chewbacca: sometimes the best investment can be a little bit ugly and hairy and you’ve got to scratch beneath the surface to fund the gem within. Sometimes an unloved, unpopular and generally disliked investment can provide the best returns. Being contrarian and not following the herd can yield great results – just be sure that what you’ve found really is Chewbacca and not a cranky bear that wants to bite your nose off.
Finally, an important Star Wars lesson comes from that big slobbery thing known as Jabba the Hutt. He’s the one who freezes Han Solo in carbonite for use as a nice wall hanging, all over an unpaid loan. The message here is this – you may be good-looking and captain the Millennium Falcon, but too much debt can stop you in your tracks as effectively as a collapsed black hole. Watch your debts Luke! One more bonus lesson from Star Wars – if you do buy your kids light sabres, get them the foam ones first, it’ll save a lot of tears that can’t be fixed by any amount of Force.
Let go of the anchor
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 18 June 2016.
In an ideal, theoretical world, human beings are all rational, clear-thinking individuals, able to make perfect decisions and choices every time. The reality however, is very different. We’re an emotional bunch, prone to letting our fears, aspirations and biases override our common-sense. Our emotional biases also unfortunately impact our investment decision-making. One of the most common biases is that of ‘anchoring’. Anchoring is the tendency to erroneously assign too much importance to irrelevant information. For example, you might buy shares in a company for $5. Bad news causes the share price to fall, but you refuse to sell, stating that you’re going to wait until it gets back to $5 before selling. The $5 level is irrelevant, it just happened to be the price at which you bought the shares. It has no relevance at all in regards to the current value of the investment. If you had bought in at $4.50 you would probably use that as your trigger level. Neither figure carries any importance except that which you assign them in your own mind. You’ve become irrationally anchored (or fixated) on a random price and this anchoring is affecting your decision-making. If it’s a poor investment it should be sold, rather than hoping it’ll get back to your break-even.
The problems associated with anchoring are not restricted to just the stock market. Most people have had a conversation with someone who is selling their home who says something along the lines of “…well I paid $400,000 three years ago, so if I can get that back I’ll be happy…” Again, that’s anchoring. The price you paid for your home however many years ago has no bearing on its value today. You should assess the value of your home (or shares) on its merits, with no consideration of what you paid for it. Of course, because we are emotional beings, that’s hard to do. Too easily we entangle our decisions with our emotions. Avoiding the problem of anchoring can be difficult; it’s impossible to just ‘forget’ what you paid for your house or shares. One way is to get someone else to make the decision for you, someone who is not subject to the same anchoring bias. Someone who doesn’t care about the price you paid is more likely to make an objective decision on the value of your shares (or house). And a mountain of academic research has shown that objective decision-making, at least in an investment context, is far better than an emotion-driven process. So next time you need to make such a decision, let go of your anchor or ask somebody to do it for you.
Nothing lasts forever
This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 4 June 2016.
Due to an equipment failure, I have recently been on the lookout for a new microwave. The now inoperable microwave which we had owned, was only around four years old, so I was less than thrilled to be having to replace it so soon. This seems to be the way with electrical appliances these days – last year our washing machine stopped working after less than five years and also had to be replaced (just as costly to fix as to buy a new one, according to the repairman). In both cases it seemed that the mechanical gremlins had arrived way too early – a 2007 study into the ‘Life Expectancy of Home Components’ by the US National Association of Home Builders estimated that microwaves and washing machines had life expectancies of 9 and 10 years respectively. On a human equivalent, both of my appliances died in their forties, a very early passing.
When it came time to look for a new microwave, I naturally started with the internet. It turned out the microwave I needed to buy was the Panasonic NE-691, loved by its owners and with the oldest working example being nearly 40 years old. As should be expected however, Panasonic stopped making that model decades ago; probably too reliable I imagine. Now you’re lucky if you can coax a few years out of your latest appliance; where an appliance was once seen as an investment, they’re now nearly throw-away items.
When it comes to shares and investing however, you should expect more than a few years of gainful ownership. That’s not to say that investing is a set and forget approach, far from it. Changes in management, technology, the economic environment and consumption patterns are just a few of the factors which influence the performance of a company over time. The trick is to find the balance between the day traders who think 10 minutes is a long time to be a shareholder, and those who think the ‘buy and hold forever’ approach is the way it’s done. What’s certain is that the average holding period (the length of time investors typically hold their shares before selling) has been falling over time, by some estimates now averaging only 5 days in the United States. Some companies can be safely held for years, others need far closer scrutiny. They’re all different, so do your research, as I should have done before buying the microwave with the four year expiry date.