Becoming aware of Behavior Biases

If you read a textbook on investing, it would say that all investors are in search of profit and make “profit-maximizing” choices in their best interest and in an efficient way.  However, as is true in many parts of our lives, we see a disconnect between how we believe things should occur and how they actually occur. A big reason for the discrepancy between the “textbook answer” and the “real world answer” lies with human psychology and our emotions. In investing we attribute the real-world outcomes to various behavioral biases that afflict all investors. Behavioral biases are elements of human psychology that can negatively impact long term investing performance as they are typically associated with our desire to make decisions based on emotions–fear or greed, rather than logic and process. The Oakmark Funds, an $86 billion asset manager that we follow given their thoughtful research and insights, recently discussed behavioral biases from which millennials tend to suffer. It has been our experience that it might be unfair to single out just millennials for these investment foibles, and think all investors should be aware of behavioral biases such as the ones discussed below in looking to achieve their long-term objectives.

Why Millennials Should Own Value Stocks by the Oakmark Fund’s Lauren Digani, CFA (emphasis by Madison)

As a millennial working in the investment industry, trends impacting younger investors tend to pique my interest. Millennials (individuals born 1981–1996) are currently in a life stage marked by major financial decisions with large purchases, debt repayment and savings vying for attention. Regardless of an individual’s priorities, one point is difficult to dispute: how millennials invest can have serious implications for their long-term financial wellbeing.

From an asset allocation perspective, millennials generally seem more interested in owning high-flying technology stocks than traditional value names (stocks trading below their estimated worth). A recent Business Insider survey indicated the millennial subset’s favorite long-term stock picks are technology-oriented mega-cap companies with the top three responses (Amazon, Microsoft and Apple) representing nearly 20% of all votes. Yet millennial investors, more than any other demographic, may be best positioned to benefit from at least some value exposure in their equity portfolios.

The Millennial Mindset

Before exploring why millennials should own value stocks, it’s helpful to understand why they typically don’t. By now, the image of an experience-mongering millennial in pursuit of instant gratification is cliché; however, several well-documented behavioral factors may be contributing to millennials overweighting traditional growth stocks.

• Familiarity bias– Instinctually, people favor what they know. Familiarity can cause individuals to be loyal (sometimes irrationally so) to the things they’re exposed to most. For millennials, this bias commonly manifests itself as confusing “products I use regularly” with attractive investment opportunities. For example, shopping daily on Amazon should not drive a decision to buy the company’s stock.
• Social proof– The cognitive tendency to base one’s own behavior on that of others is known as social proof. For millennials, this factor is amplified by the integral role that technology plays in day-to-day life. In particular, social media and online review culture (i.e., seeking solutions that are “highest rated” or “most popular” among peers) may make millennials more likely to pursue top-performing or broadly recommended stocks when making investment decisions.
• Loss aversion– According to behavioral economists, individuals prefer avoiding losses to acquiring gains of equal magnitude. This cognitive bias explains why the pain of losing $20 outweighs the excitement of finding $20. In a relatively short timeframe, millennial investors have experienced three major market declines (driven by 9/11, the global financial crisis and Covid-19), potentially leading them to avoid historically out-of-favor value stocks for fear of suffering additional losses.

Setting Up for Success

Recent headlines indicate that many millennial investors have used pandemic-related volatility to increase their equity exposure. In tandem, the introduction of mobile apps that place investment opportunities at one’s fingertips (and even offer “free stocks” for downloading) has broken down the perceived barriers to investing for millennials. In light of greater accessibility—and our human behavioral tendencies—why should millennials own value stocks?

1. Fundamentals are important. Benjamin Graham and David Dodd laid the foundation for value investing in Security Analysis,² published in 1934. The book encouraged readers to estimate stocks’ intrinsic values using fundamental factors, such as company assets, earnings and dividend payouts, then seek securities trading at discounts to those values. Nearly a century later, fundamentals still matter, although they are sometimes overshadowed by enthusiasm around a particular company or dynamic CEO. For instance, Tesla (the number four response in the millennial stock pick survey) trades at an enterprise value 10 times that of Daimler (Mercedes-Benz) or BMW, which also have burgeoning electric vehicle businesses. Despite these valuations, Tesla generates significantly less cash flow than either peer and underperforms both on key fundamental metrics. At Oakmark, we view the relationship between a company’s share price and its underlying fundamental value as central to investment success. By employing a team of experienced analysts whose primary mandate is to identify price-value discrepancies, we implement a disciplined, fundamentals-based approach that can unlock value on behalf of our investors.
2. Diversification reduces risk. Results of a recent Glassdoor survey identifying millennials’ top 10 target employers look eerily similar to their list of favorite long-term stock picks. However, over-concentrating in shares of a company (or industry) in which one works can have dire consequences. For example, in 2001, 62% of Enron employees’ 401(k) assets were in company stock, leaving thousands of people to rebuild both careers and retirement savings upon the firm’s collapse. Aside from diversifying employment exposure, value stocks can offset outsized weightings to momentum stocks in passive portfolios. By trying to play it safe in a market-cap weighted index fund, millennials may unintentionally invite risk by loading into a handful of popular names.
3. A long time horizon creates opportunity. With even the oldest millennials looking at 25-30 years until retirement, this investor group has a relatively long-time horizon. In value investing, patience presents opportunities. Oakmark has demonstrated over four decades of managing portfolios that discipline in the face of short-term volatility can reward investors. In contrast, attempting to outguess near-term price movements is a speculative task. Although trading has become cheaper and easier for millennials, leveraging these trends to chase performance may not produce long-term benefits.