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August 11, 2016

Investments: The risk of “I should have…”

Investments: The risk of “I should have…”

By Andró Griessel.

“You should have sold your Richemont shares three years ago already.  You did not earn a cent in growth in the last 3 years; in fact you lost 15% of your capital!”

If the above comment doesn’t bother you, you are probably someone who is susceptible to cognitive biases.

The above comment represents a typical case of hindsight bias. By looking back at what happened to the share price, it now seems obvious that you should have sold at the peak.

Hindsight Bias is one of the most common cognitive misconceptions that we fall prey to, but definitely not the only one.

During the next few weeks I’m going to point out some of these cognitive potholes, based on some personal experiences I have had with clients.

Almost across the board, these prejudices, now or in the future, will result in financial losses for those who make these mistakes.  If you are aware that these mistakes can creep into your thought processes, you can try (and even succeed), in avoiding them.

As you could have guessed, my example this week relates to Richemont and specifically to an incident where I tried to convince a client, who inherited a substantial Richemont share portfolio, that the concentration of her portfolio in this one stock does not represent an optimal risk/return opportunity set.

At that stage one Richemont share traded for around R100.  Besides the fact that based on a historic price to earnings ratio, the share was expensive, my biggest concern was the fact that almost 60% of the client’s total investment portfolio was concentrated in this one share.  Even if this share was substantially less expensive, the concentration risk was not worth taking.  The risks (combination of valuations and concentration) formed the basis of my advice.

Not as clever as you look

Today, almost 3 years later, 1 Richemont share is trading for around R 85.  With the benefit of hindsight, my initial recommendation seems quite clever.  It would be very easy for me to succumb to yet another cognitive blunder, i.e. over-confidence bias.  But let’s be honest, not me, nor the man on the moon, could have known 3 years ago that a Richemont shareholder would lose 15% of his capital during the subsequent 3 years.  Remember, at that stage Richemont shares gained more than 250% in the preceding 3 years (from August 2010 until August 2013)

You can just imagine how unpopular this recommendation was.

What actually blew me away and where I realised that even professional practitioners can make big cognitive errors, was when I approached a very respectable stockbroker for his opinion on how I should approach this portfolio, confident that he would take my side.

His recommendation was that the client should sit back and do nothing.

So obviously, if you turn back the clock 3 years and consider the capital gains tax implications that would have been triggered, his argument does seem relatively reasonable.

Try this easy test

If we subject this logic to a very modest test, then the stockbroker’s recommendation is far from appropriate though.

The test is simply this: If I would give the stockbroker an equivalent amount (in cash) to invest for the long term, how would this portfolio look like? In other words, which shares would he have bought?  Surely he wouldn’t recommend that 60% of these funds be invested into a single share, especially not at that price.

One or more of the following cognitive errors was probably at play with both the investor and the stockbroker:

Status quo bias:  In situations where the alternatives are uncertain, people tend to stay with the familiar, especially if it has treated them (very) well up to that point.

Fear of regret:  The pain of a (new) decision that leads to a loss is felt more acutely than the absence of a decision, have you missed out on an opportunity.  In the Richemont example, it would have been a far more painful experience for the investor to sell the Richemont shares and make a loss with the proceeds after investing it elsewhere than the joy or satisfaction that he would have experienced if the new shares he bought ended up doing great.

Failure bias:  This is very similar to the fear of regret and probably more applicable to the broker (whereas the above biases were more applicable to the client).  The decision to do nothing (keep the Richemont share) is much easier to defend, even if the decisions turned out to be wrong, than what it would be defending a bad outcome that was the result of an active decision.

To close off, one of the most common mistakes, that investors, financial planners and market commentators make is to judge the quality of their decision based on the (often temporary) outcome of that decision, the so-called outcome-bias.

If you decide to drive yourself home at 160km/h after 10 brandies and you arrive there safely (i.e. a good outcome), was this a good decision?  Absolutely not!

Was the recommendation to sell a substantial portion of you Richemont share the best advice?  In hindsight, it probably was, but would the client have thought so if the share continued to soar?  Probably not!

This notion (to judge the quality of your decision based on the outcome) is plain wrong!

The quality of the decision should not be judged based on the outcome, BUT rather on the process that was followed and work that was done to reach that decision in the first place.

* Andró Griessel is a certified financial planner and the managing director of ProVérte Wealth & Risk Management.  Follow him on Twitter @Andro720911.  He writes twice a month for Sake24.

Disclaimer: Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.

Andró Griessel
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