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Youth vs experience

James Norrington explains why understanding how cognitive biases differ across generations can make us all better investors
Youth vs experience

Inter-generational friction is nothing new. Before even the first post-war baby boomers hit their teens, the cohort born a decade earlier were idolising James Dean’s character, Jim Stark, in Rebel Without a Cause (1956). By the time boomers were coming of age in the 1960s, youth culture had flowered into a social revolution powered by sex, drugs and rock 'n' roll.

Or so the myth goes. Popular memory of the 1960s is coloured by images of 'flower power' and psychedelia, but the Summer of Love probably passed most young people by. Just as baby boomers weren’t all polyamorous pot-heads, millennial adults haven’t unanimously earned some of the perceptions formed of their generation. Stereotypes can be amusing and often hold a kernel of truth, but they are also lazy. Contrary to labels of fecklessness, many of today’s 20 and 30-somethings demonstrate characteristics their older counterparts could learn from to become better investors. Furthermore, some of the charges levelled at young people stem from cognitive biases equally evident in common portfolio mistakes by Baby Boomers and Gen-Xers, too.

Bad choices are largely down to the way our brains work, which is largely the same young or old. Prospect theory (first developed by Kahneman and Tversky in 1979) postulates that people make decisions based on their expectations. This differs from classical economics, which assumes price equilibriums are found between cost and actual utility derived. Working out the prospects of an outcome requires imperfect forecasting and many people rely on mental short-cuts or ‘heuristics’ to approximate probabilities. Results are often sub-optimal, such as overpaying for a stock or selling it too early.

 

Why your portfolio probably says you’re a snowflake too

One memorable passage from Chuck Palahniuk’s cult 1996 novel Fight Club is credited as inspiring the use of 'snowflake' as a pejorative term for millennials: “You are not a beautiful and unique snowflake. You are the same decaying, organic matter as everyone, and we are all part of the same compost pile.” The etymology of the insult is disputed (a recent Esquire feature noted snowflake was used before the American Civil War, paradoxically to describe anti-abolitionists), but the modern sentiment is that millennials (or Generation Y) are self-absorbed and entitled.

Millennials in the workplace may be chastised for wanting the trappings of success without putting in hard graft (the national press seized on Britain’s Confederation of British Industry (CBI) finding that a third of its members, surveyed in 2017, were dissatisfied with graduates), but most age groups misunderstand the trade-offs (in investing that means risk-to-reward) that must be made for personal gain. The Investors Chronicle portfolio clinic regularly provides anecdotal evidence that equity investors don’t appreciate the depth of losses that can be suffered (the MSCI World Index lost 54 per cent of its value in the 2007-09 bear market). Despite this, required rates of return are frequently stated as being above the annualised 5.3 per cent, in real terms, that has been observed for world equities between 1968 and 2017 (Source: Credit Suisse Global Investment Returns Yearbook 2018, by Elroy Dimson, Paul Marsh and Mike Staunton).

Imbalanced portfolios demonstrate that investors are not risk-averse in their asset allocation, but they are certainly loss-averse. Failure to set realistic objectives and expectations of losses at the outset leads investors to try to manage risk in their portfolios heuristically. In doing so, our psychological tendency to pursue actions that generate feelings of pride, and avoid outcomes that lead to regret, is at the root of many poor decisions. Labelled the “disposition effect” by psychologists, in practice this means investors often take gains too early (failing to run their winners for maximum impact) and keep bad holdings too long (in the forlorn hope they will recover) to avoid crystallising losses. Aversion is partly down to the capacity to bear loss, but not wanting to feel stupid or foolish is an important emotional motivation. When it comes to our portfolios, it seems, we are all hyper-sensitive snowflakes.  

Participation medals and the idea that ‘no-one comes last’ have become popularised (and probably overblown) in the media as representative of millennials’ education. The sentiment behind sheltering children from losing is derided, but not wanting to stand out as worse than peers has also been used to expand loss aversion theory. It is psychologically easier to be wrong in a group, as material loss isn’t accompanied by humiliation. On the flipside, humans are social apes and don’t want to miss out or feel excluded from gains, so herding has been a recurring theme throughout history from tulip bulbs to the tech bubble. You don’t need to be born after the early 1980s to fall prey to these cognitive dissonances that impact investment performance.

 

Investing in the frame as a behavioural leveller

Another prominent theory in behavioural finance is that investors frame predictions in the context of reference points from their own experiences, with more weight attached to emotionally significant events. Going by the IC portfolio clinic submissions, expectations of equity market returns have been skewed by the bull market since 2009. The 2018 yearbook by Dimson, Marsh and Staunton shows the annualised real rate of total return for global equities has been 8.3 per cent between 2010 and 2017. In the US alone, the figure is an even more impressive 11.2 per cent. Of course, this occurred in recovery from the nadir of one of history’s worst bear markets – a recovery aided by major central banks running the largest programmes of monetary stimulus ever. It is in the context of these rates of return that many investors, of all ages, have framed their perceptions of what is a reasonable performance for equities going forward.

In fairness, there is an acknowledgement that spectacular rates of return won’t continue indefinitely. Demonstrating a concept from prospect theory called anchoring, however, investors do still base even moderated expectations of returns on the recent past. The psychological anchor for estimates is often the entry point (the price for a stock or the net asset value for a fund at which the first investment is made); or the rate of return since inception of the portfolio (or over some arbitrary time frame like one, three or five years). Investors who have made 10 or 12 per cent a year in the past decade make their estimates from this anchor point. They may think it modest to allow for ‘only’ 5 or 7 per cent a year over the next few years but, rather than lower expectations using an above-average decade as the starting reference, it would be prudent to forecast from the (lower) longer-run rate of return.

The danger for millennial investors, who have only known a bull market, is that they have too few frames of reference. Compared with their older counterparts, who experienced a lost decade for equities as recently as 2000-10 (real rate of returns was -2.3 per cent in the US and -1.3 per cent globally), Generation Y investors are more confident that stocks will continue to rise. In March 2018, website SyndicateRoom’s Big Investor Survey (carried out by FTI Consulting) found that younger investors were proportionately more likely to have a positive outlook for equities over the next 12 months. They found that 75 per cent of 18 to 30-year-olds (out of a weighted base of 196) believed shares would rise, versus 61 per cent of 30 to 50-year-olds (out of 432) and 53 per cent of those aged over 51 (out of 633). This suggests the framing effect of the long bull market may be greatest among the young but, before we accuse them of naivety, it is interesting that more experienced investors also skew their expectations to the upside.

Over the past decade, it seems many investors have developed, dare we say it, a sense of entitlement to stellar equity returns and relatively low market volatility. Discussing Generation Y, in a Youtube interview in late 2016, US organisation consultant Simon Sinek highlighted “bad parenting” (not his words, he stressed) as one of the reasons for entitlement. The theory is millennial children were given rewards too easily and became used to getting their way just because that’s what they wanted. The same might be said of the stock market since 2009. Ultra-low interest rates and quantitative easing programmes by the world’s major central banks saw markets rise high on a tide of liquidity. Making money from the market required no thought – just buying an exchange traded fund (ETF) tracking the S&P 500 would have delivered outstanding returns. Has the 'lax parenting' of central banks spoilt investors and made them less inclined to acknowledge downside potential?

An alternative explanation for optimistic framing across generations might lie in nature rather than nurture. Work by Dr Tali Sharot and her team at University College London has produced strong evidence that the human brain has an optimism bias. For example, people getting married may know that over 40 per cent of marriages end in divorce, but they rate their own chances of suffering that fate at a significantly lower probability. This is because the optimistic side of the brain, the left inferior frontal gyrus, responds to good news more strongly than the pessimistic equivalent, the right inferior frontal gyrus, responds to negative information. The tendency of investors to look to the upside could be another manifestation of this hardwired optimism.

Our brains have evolved over millennia, so intuitively it should be unsurprising impulses underpinning behaviour don’t alter across generations. Points of reference are formed by cultural and educational experiences, though. Trends all investors have lived through, such as the quantitative easing (QE) era post-2009, have stimulated cognitive biases, but older investors who have seen more booms and busts draw from more experiences. This is reflected in attitudes to different styles of investing and sectors. For example, many older investors were burned in the tech crash at the turn of the millennium. By contrast, Generation Y were still in school at the time. They have grown up immersed in tech – so have a more intuitive idea of which communications services will resonate. Another anecdotal finding from the IC portfolio clinics is that older investors are likely to be underweight tech while younger investors are likely to be overweight – given the pace of technological change, this could prove a mistake for older investors.

 

Can we define portfolios or styles of investing by age?

That said, there is also a tendency to become fans of certain companies, which can cloud judgement. New mobile apps such as Dabbl have emerged to help millennials invest in brands and companies they love. It is true that Warren Buffett is a great believer in buying a brand (and is famed for loving shares in Coca-Cola (US:KO) as well as the cherry flavour of the product), but Mr Buffett’s investing is backed up by solid analysis of financial fundamentals, not just fandom. It must be remembered, however, that Mr Buffett regards not buying sharers in Google and Amazon (AMZN) when they were cheap in 2009 as mistakes. In part, his reluctance was generational and due to being less at ease with technology – Mr Buffett credits Bill Gates with telling him to stop using the primitive Altavista as his search engine – but it could also have been a scepticism hangover from the dotcom crash. Sitting on the sidelines saw Berkshire Hathaway miss out on some major gains from Big Tech in the early part of the post-2009 recovery, with Google – since 2015 incorporated as part of holding company Alphabet (GOOGL) – and Amazon in particular going from strength to strength.

Younger investors have less reticence in backing digital advances that shape their world, but they ignore lessons of the past at their peril. Understanding of a business model goes beyond technology trends or a brand – as those who bought into pets.com in the late 1990s can testify. Revenue recognition, sustainability of earnings growth and the conversion of accounting profits to hard cash need to be assessed and understood when buying shares in individual companies. If you’re going to buy a portfolio of brands passively, without doing this research, then it is more sensible to go for an index tracker. This will be more diversified, include companies with big brands anyway and save on dealing charges. Gimmicks, like brand-led investing apps, may appeal to our availability bias – overweighting information because it comes in our preferred format (in the case of millennials via their smartphones) – but they should be subject to added scrutiny.

It is not the case that mistakes by millennials seen in the IC portfolio clinic occur through a lack of rigour, however. A fairer observation would be that overconfidence in future trends could be leading them to take unnecessary risk. For example, one 25-year old was making some very sensible lifestyle decisions (flying in the face of generational stereotypes), but his investments were too concentrated, thanks to a firm belief in growth for the electric vehicles market. It’s fine to back a trend, but there is the risk of being wiped out if any of the companies you’ve picked get disrupted by smarter iterations of technology. With only a relatively small starting pot, taking a concentrated approach could lead to major setbacks. True, people in their 20s have time to recover, but reinvesting dividends and with the power of compounding on their side, Generation Y can go for broader, lower return (and therefore lower risk) portfolio strategies and still do very well over the long term.

 

 

Holistic thinking trumps mental accounting

One of the impressive characteristics of some young people who submit to the portfolio clinic is that they have grasped the importance of thinking about wealth holistically. This overcomes another major cognitive dissonance: mental accounting. In a portfolio of shares, this is the tendency to treat each holding individually and works alongside the anchor bias. Building an emotional attachment to the performance of a stock relative to the entry price anchor can mean sub-optimal choices. It is better to decide whether to cut losses or run profits based on the role that stock plays in the risk-reward profile of the whole portfolio. More broadly, mental accounting can mean creating artificial budgets. For example, an individual may have a cash savings account and a current account for living expenses. Poor outcomes can result from looking at accounts disparately, say if the current account is overdrawn and borrowing is at a higher rate of interest than that received on the balance of the savings account.

This hypothetical budgeting example is probably more pertinent for younger people, but there are good case studies from this demographic for overcoming mental accounting. Recently, Investors Chronicle had a portfolio clinic submission from a 26-year-old man who, far from being despondent about economic challenges, was utilising the advantages of youth. With the benefit of good health and few responsibilities, he had relocated to India. Migration is such an emotive issue precisely because birthplace is a huge determinant of opportunity. Freedom of movement, however, doesn’t just mean poor people re-settling in richer countries.  As in the case of our reader, being an economic migrant to a cheaper country can help money go further and decrease the proportion of earned income that disappears on rent.

Before investing a penny, decisions to maximise efficiency of human capital – the ability to work and choose where you live – help build wealth. Technology is important too; as a digital native (at ease with the latest communications technology) our reader can progress his career outside of an expensive western metropolis. There are also positive translation effects if earnings made in, say, US dollars or sterling are converted into rupees. The upshot is taking a holistic view of income, mobility, technology and freedom maximises disposable income and, therefore, the opportunity for investment. It also utilises that greatest advantage of youth: time.

The question of whether youth confers any other benefits for investing can be controversial. It might be tempting to speculate that neural pathways become less malleable with age, but this would be pure conjecture. Neuroscientists such as Dr Sharot stress that sweeping statements and hypotheses should not be made without the basis of solid research. What has been observed is that people of all ages tend to be more willing to believe information that conforms to their existing prejudices. Different generational groups should be mindful of this when evaluating their portfolios and each other.