Beating Bias with Systematic Discipline

Markets work because we as humans are wired to be tenacious and hopeful proprietors of our own legacies – it’s part of our emotional DNA; but with that comes emotion, the implications of which must be carefully navigated when making investment decisions. Emotion is perhaps one of the most beautiful aspects of humanity, yet it introduces a number of biases that all of us are susceptible to – especially investors. Unfortunately, many of these biases tend to flare up rather inconveniently – particularly during times of crisis when discipline is needed most. As Benjamin Graham, former instructor of Warren Buffett who is now widely-recognized as the Father of Value Investing – once put it, “Wall Street has a few prudent principles; the trouble is that they are always forgotten when they are most needed.” Said differently, investing isn’t about beating others – it’s about controlling yourself in order to win the game – and therein lies the focal point of today’s discussion.

Let’s begin by rewinding the clock to late February 2020. Markets were selling off at a rapid clip as a highly contagious, poorly understood virus began to spread rapidly around the world. Interest rates plummeted as equities followed suit, and within a matter of weeks the S&P 500 was more than 35% off its recent record high. This led many investors to liquidate their investments in the midst of the selloff, and even after the market sharply reversed course and continued to rally through year-end many were reluctant to reinvest because “it just didn’t make sense.” For many (including myself), it was hard to believe the rally that had taken place as there was an underlying fear that another virus-induced selloff would soon ensue – leaving millions of investors on the sideline as the S&P 500 bounced more than 60% from its March low through year-end. Many investors then found themselves reluctant to invest when the market was trading near all-time-highs – waiting for what seemed to be a long-overdue correction despite the positive expected return that most financial assets should inherently offer. The market’s swift rebound back to record highs of course made many investors nervous, but if there’s one thing history has shown us, it’s that a stock peak isn’t a cliff – and according to the research provided by Austin-based Dimensional Fund Advisors, it’s quite the opposite.

Now fast forward to the most recent selloff – one characterized by rising interest rates, hot inflation data, and mounting geopolitical tension – wherein many companies (especially tech firms whose valuations depend more on future growth versus current earnings) quickly sank into correction territory as the market’s speculative bullishness begun to unwind. Understanding the inherent tech concentration in most major indices (with Facebook, Apple, Netflix, Microsoft, Amazon, Google, and Tesla representing nearly 30% of the S&P 500), many investors were asymmetrically hit by the selloff and felt inclined to hold their losing positions because “things have to turn around at some point, right?” It’s one thing for a blue-chip name like Amazon to trade 15% off its record high, but what about companies like PayPal, Zoom, and Peloton – the pandemic’s fallen angels that have now declined more than 55%, 65%, and 75% (respectively) over the past year? At what point does one double down or admit defeat? While the answer is very much case dependent, there are many instances in which realizing a loss can be more difficult than continuing to ride an unrealized loss – neglecting the idea that there may be a more efficient use of capital at that point in time. Confronting a failed investment can be difficult, and the clouded judgment resulting from such disposition – a bias referred to as loss aversion – can be detrimental to the accomplishment of long-term financial goals.

While some might argue that they possess some innate ability to time markets (overconfidence bias), the basis for such confidence (or lack thereof) was likely influenced by personal experience in the market – both good and bad. Unfortunately, this leads many investors to dismiss new information at the expense of subjective judgment – justifying a decision that may seem logical at the time but is often ungrounded in economic reality. This phenomenon (referred to as recency bias) confusingly goes hand-in-hand with most other cognitive and behavioral biases, and for someone spooked by a 5-10% correction or attempting to time the occurrence of such corrections – emotionally reacting to market volatility can be a serious detractor of returns over the long-term. Just take for example the below chart that highlights every 5% and 10% drawdown over the past 95 years – imagine the luck it would take to time each correction perfectly and the opportunity cost of being wrong. That’s not a bet I’m willing to take!

These are mere examples of the many biases we as investors naturally face, and whether it be an overwhelming inclination to sell or some emotional tie to a losing position, it’s very easy to find information that justifies our decisions – right, wrong, or indifferent. Downturns and volatility are simply part of investing, and though we can’t control markets, we can control our reaction to the market. The most difficult aspect is knowing when to draw the line between objectivity and subjectivity, and more importantly, being disciplined enough to confront these biases when they begin to cloud our judgment. As discussed in our previous commentary, investing is a delicate balance of art and science – and at Silicon Hills, we’re actively confronting these vulnerabilities via a number of systematic, rules-based processes. In doing so, we have thoughtfully bifurcated our investment program into three sub-strategies – Hedging & Income, Global Trend, and Global Equity – each of which is supported by quant-based, systematic strategies that provide objective output free of emotional interference. However, we also understand that nothing works all the time – and whether it be our own in-house models or those of our investment partners (such as Dimensional Fund Advisors and Avantis Investors) – we recognize that objective output still requires subjective, independent scrutiny. Investing is just as much art as it is science, and at Silicon Hills, our investment program runs on math but remains subject to the confines of common sense – mitigating the influence of our own emotional biases without becoming overly-reliant on the data itself. Just as a car consumes gasoline yet requires the skill of a knowledgeable driver, navigating the market requires an understanding of when and how to embrace math versus common sense. So even as we hit a few inevitable bumps in the road, our clients can rest easy knowing that the tank is full and the driver is alert – willing and able to stay the course across all market environments.

About the Author

Dean Rogers, CFA

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