How to Make
Better Decisions
Module Menu
Consumers occasionally purchase items and shortly afterward experience “buyer’s remorse” or regret about buying something that they don’t need. In fact, an estimated 52% of people have purchased an item on sale that they later regretted.
A wide range of emotions can adversely influence decisions. With that in mind, this module seeks to help you become a better investor by understanding behavioral finance and the role that emotions can play when making portfolio decisions.
Pitfalls
How can you combat your investing biases that often lead to underperformance? You first have to understand them.
Brad Neuman, CFA
Senior Vice President
Client Investment Strategist
ALGER
Click on one of the common biases below to learn how it can impact your investment decision. Later in this module, we discuss ways to beat them.
OPTIMISM BIAS
What is it?
Individuals have a tendency to forecast close to best-case scenarios. In one example, people flock to casinos with hopes of winning.
Evidence
In hopes of large returns, investors are drawn to volatile stocks, which persistently underperform.
Investing example
You make forecasts based on instinct and find that reality often fails to live up to your expectations.
Do you suffer from it?
So What Can You Do?
Here are some important points that explain the shortcomings of the inside view:
About 90% of worldwide transportation projects underestimate the actual costs.
HERDING BIAS
The undue influence of a group upon decision making, just like horses stampeding. If everyone is doing it, it must be right!
What is it?
People agree with obviously wrong answers more than one third of the time to conform to a group.
Evidence
Newsweek summed up the 1999 bubble frenzy with the headline: "Everyone's Getting Rich But Me." We know that ended badly.
Investing example
Investment decisions based on opinions from friends and acquaintances rather than independent work.
Do you suffer from it?
Listen to Alger's thoughts on the power of the outside view and how analysts and portfolio managers typically incorporate this view.
You don’t have to fall victim to the biases described above. By using an outside view you can understand why decisions often miss the mark and you can potentially choose more wisely.
An outside view considers the experiences of other individuals. For example, when a future homeowner estimates the time required to build a house, the individual can use an outside view that includes the amount of time that numerous contractors have needed to build similar homes. This can result in improving forecasting or decision making.
To understand forecasting challenges, consider the following question:
Inside View
• Derived from specific circumstances
• Uses evidence from own experiences
• Qualitatively formed
• Only accounts for known variables
Here is an explanation of the outside view and why it can be a powerful tool when making decisions:
Confirmation Bias
People seek data that are compatible with their beliefs. For example, believing left-handers are creative and then seeing a creative left-handed person as validation.
What is it?
Paying attention to media outlets that support your political views rather than seeking out alternative points of views.
Evidence
Many investors held on to the view that newspapers are great businesses without heeding data regarding internet disruption.
Investing example
You tend to seek out opinions and data points supportive of your view and dislike hearing opposing views.
Do you suffer from it?
Representativeness Bias
Judging based on observable characteristics with little or no regard for prior probability.
What is it?
People are much more likely to forecast based on “similarities” instead of reference group probabilities.
Evidence
Studies have shown that switching investment managers solely because of short-term performance is a strategy that produces sub-optimal results.
Investing example
You have developed rules of thumb that can quickly conclude if an investment looks promising.
Do you suffer from it?
Loss Aversion Bias
Fear about potential loses such as declining stock prices is felt more acutely than emotions associated with the prospect of realizing investment gains.
What is it?
Studies show that a potential investment gain typically needs to be 2x the amount of a potential loss to entice individuals to overcome their fear of incurring a loss.
Evidence
Many people view equities as too risky because of the chance of losing money, despite the potential for positive long-term performance.
Investing example
You avoid selling at a loss despite the fundamental outlook being dim or find it painful to be down in an investment despite positive long-term prospects.
Do you suffer from it?
Availability Bias
Decisions, such as buying home insurance, are influenced by readily available data or recent events such as natural disasters.
What is it?
Doctors’ diagnoses are influenced by the most recently observed medical disorder.
Evidence
Difference in availability of knowledge between domestic and foreign investments leads to large home country biases.
Investing example
You often relate issues to your own experience or recent data points.
Do you suffer from it?
Why? Research shows that we are generally overconfident when forecasting, which explains why the timeframes for most transportation projects are underestimated. An overly optimistic forecast is a classic example of what is called “the inside view,” which is derived from circumstances from one’s own experience. Using an “outside view of a reference class,” as you’ll learn below, can facilitate better decisions.
Source: Daniel Kahneman and Amos Tversky
of transportation projects
underestimate costs
What percentage of worldwide transportation projects underestimate the actual costs that are incurred?
Q:
A:
HERDING
BIAS
OPTIMISM
BIAS
Representativeness
BIAS
LOSS AVERSION
BIAS
AVAILABILITY
BIAS
CONFIRMATION
BIAS
Traditional finance assumes people are rational, possess objective knowledge and stock prices are efficient. Behavioral finance disagrees. It recognizes that people have cognitive biases, use subjective judgement and project their biases onto investment decisions.
1
(1) Solomon Asch, “Opinions and Social Pressure,” Scientific American, Vol. 193, No. 5, November 1955.
(1) Bent Flyvbjerg, Mette Skamris Holm and Soren Buhl, “Underestimating Costs in Public Works Projects: Error or Lie?,” Journal of the American Planning Association, vol. 68, no. 3. (Summer 2002). (2) According to Northfield data, the price volatility factor has underperformed by over 50% over the past 15 years ending 06/30/18.
1
2
(1) Kahneman and Tversky, 1973. (2) The Journal of Portfolio Management, Bradford Cornell, Jason Hsu and David Nanigian, December 2017.
1
(1) Daniel Kahneman, "Thinking Fast and Slow," 2011, FSG.
1
(1) Klein, Jill G. “Five pitfalls in decisions about diagnosis and prescribing,” 2005, BMJ (Clinical research ed.). (2) Vanguard, “The Global Case for Strategic Asset Allocation and an Examination of Home Country Bias,” February 2017.
1
In some instances buyer’s remorse results from individuals being influenced by a group, such as when friends or acquaintances flock to a store in response to big sales such as Black Friday events. The undue influence of a group upon an individual’s decision is called the Herding Bias, which can occur in everyday life such as when making investing decisions.
Behavioral finance explains why we sometimes make bad decisions. In this module, we discuss how the Herding Bias and other cognitive biases can unduly influence investing decisions. We also provide tools that investors can use to potentially avoid falling victim to cognitive biases.
Take a look at the interactive chart below:
How Does This Relate to Investing?
Click here to find out
Emotions often cause investors to make poorly timed buy and sell decisions. Click here to view an example.
Research shows that we are generally overconfident, which explains why costs for most transportation projects are frequently underestimated. An overly optimistic forecast is a classic example of what is called the "inside view,” which is derived from circumstances from one’s own experience. Using an “outside view" (or a reference class), as you’ll learn below, can facilitate better decisions.
Click to view an example
When estimating the time required to pack for a vacation, the inside view only involves estimating how much time it will take to pack each item.
Buying during market peaks and selling during dips has resulted in investors generating an annualized return of only 8.3%. Click here to see what would have happened had investors taken a different approach.
Investor Return in U.S. Stock Funds
10-Year Annualized Return
8.3%
Source: Mind the Gap 2018: Morningstar for 10 years ended March 31, 2018
Actual U.S. Stock Funds' Return
9.7%
A buy and hold approach generated a 9.7% annualized return, nearly 1.4 percentage points higher than investors’ actual return.
Introduction: How to Make Better Decisions
Improve Your Decisions by Avoiding Psychological Pitfalls
So What Can You Do? Look Outside.
Rational Decision Making Can Potentially Improve Performance
Further Reading
10-Year Annualized Return
Source: Mind the Gap 2018: Morningstar for 10 years ended March 31, 2018.
Traditional finance assumes people are rational,
possess objective knowledge and stock
prices are efficient.
Behavioral finance disagrees.
It recognizes that people have cognitive
biases, use subjective judgement and project their biases onto investment decisions.
How can you combat your investing biases that often lead to underperformance? You first have to understand them.
Senior Vice President
Director of Market Strategy
ALGER
Brad Neuman, CFA
Look Outside.
8.3%
Actual U.S. Stock Funds' Return
9.7%
Investor Return in U.S. Stock Funds
How Can I Trust
Myself?
Trusting yourself can be hard given all the biases to which we are prone. Creating distance between yourself and the situation you are analyzing, however, can be very helpful when it comes to making rational decisions about your own life and your investment portfolio.
King Solomon was one of the greatest leaders of Israel and was revered as a sage who famously solved an argument between two women who claimed to be the mother of the same baby. Yet he made huge blunders in his personal life, which led to the fall of his kingdom. He is a cautionary tale of how the same person who makes sound decisions about other people who are removed from his own personal affairs can make very poor decisions about the matters that are closest to him. This is why self-distancing is so important. If you can treat your own situations as the situations of others who are not wrapped up in your life, you can make better decisions for yourself.
What is the takeaway? A subjective perspective is a prescription for failure so consider the following two viewpoints:
Now that you are able to distance yourself from your situation, continue below to learn how this can potentially improve investment decisions.
Rational Decision
Improve Performance
Investors don’t have to fall victim to the emotional biases highlighted in this module. As people facing challenges everyday they can similarly behave more logically and set themselves up for fewer obstacles. Preventing emotional pitfalls by keeping fear in perspective with an outside view can potentially improve long-term investment results and life decisions.
In investing, periods of dramatic market selloffs have historically been attractive buying opportunities because robust equity gains have frequently followed. Individuals who avoid the herd mentality of panic selling and instead use the outside view to understand that periods of strong investor pessimism and market declines that result in lower valuations can be followed by equity gains can potentially enjoy rewards.
In fact, over two decades of data show Alger Spectra Fund performance has been unusually strong after periods of large net redemption.
How Rational Decision Making Impacts Investor Performance
Wrapping Up and Moving On
Now that we know which emotional biases most of us inherently suffer from, we can put to use our mechanisms for surmounting them. Everyone can fall victim to their own emotional biases, but we believe the tools described in this presentation can help individuals make better investing decisions and better decisions overall. Keeping emotions in check with reference class comparisons and other analytical tools can potentially result in strong investment gains over the long term. At the same time, using analytical tools to avoid cognitive biases can help investors prevent, or at least minimize, the emotional wear and tear they may suffer during market volatility. Navigating financial markets can become a calmer, more thoughtful and evidence-based experience of making better informed decisions.
Further Reading
Making Better Decisions
How Does This Relate to Investing?
Pulling out of the market as it declines because of inside view-based apprehension may not be the best approach because it is hard to predict when the market will rebound as it very likely will.
From 1996 to 2018, the Alger Spectra Fund outperformed the Russell 3000 Growth Index following periods of large net redemptions. After investors got spooked and withdrew their funds, the Fund posted stronger gains than its benchmark.
Median Annual Performance Following Large Net Redemptions from Alger Spectra Fund
18.2%
3 Years
1 Year
Source: Alger, FactSet, from 1/1/96 - 12/31/2018. Class A share performance does not reflect the deduction of the sales charge. Had the sales charge been deducted, the return would have been lower.
The outside view tells us that periods of strong investor angst, as measured by redemption activity, have been historically followed by periods of strong performance, as demonstrated by the Alger Spectra Fund.
9.9%
15.7%
7.4%
How Can I Trust Myself?
Self-Immersed Perspective
First person reasoning such as “Why am I feeling this way?” is likely to lead to poor decision making. King Solomon’s self-immersed perspective resulted in bad decisions regarding his kingdom.
Self-Distanced Perspective
Third person reasoning such as “Why is he/she feeling this way?” With this kind of viewpoint, King Solomon successfully decided the fates of other people such as the two women described above.
1980s
1990s
2000s
2010s
$10M
$1M
$100K
$10K
1980
1990
2000
2010
2019
$2,772,726
Alger Spectra Fund (Class A)
$930,605
S&P 500 Index
$762,309
Russell 3000 Growth Index
$179,822
Barclays U.S. Aggregate Bond Index
President Ronald Reagan is shot.
Reagan secretly sells arms to Iran.
Nuclear meltdown at Chernobyl.
U.S. invades
Panama.
Operation Desert Storm.
Asian
financial crisis.
Y2K bug wreaks havoc.
Dot.com bubble
bursts.
9/11.
Operation Iraqi Freedom.
Subprime mortgage crisis.
Hurricane Katrina.
U.S. financial
bailout.
European sovereign debt crisis.
BP oil spill.
Hurricane Sandy.
China devalues
its currency.
Click on a year below to discover the various crises that may have caused investors to fall into emotional pitfalls despite a pattern of historical long-term gains.
Choosing wisely is paramount when it comes to achieving optimal investment results. Behavioral psychology teaches us several important lessons on how investors’ minds operate. Although economics assumes humans behave rationally, relying too much on our...
Read More
Looking Outside for Better Decisions
By using the outside view, problems and pitfalls that may have been unknowable need not be unpredictable. Looking outside of our own situations should help us make better decisions, something we care deeply about at Alger...
Watch Here
Solomon’s Paradox
Whose advice should you trust? Actually, research suggests that you can trust yourself if you are able to distance yourself from your own situation. This self-distancing can enable you to make wiser decisions in investing and in life...
Read More
Are You a Rational Investor?
Following the herd often leads investors to make poorly timed investment decisions, as negative sentiment is often followed by strong performance. In this flyer, we examine the performance of Alger Spectra Fund following periods of large net...
Read More
Avoiding the Behavioral Trap of Volatile Markets
In his latest commentary, Brad Neuman explains how employing an outside view can lead to more rational and thoughtful decision-making, and potentially better investment results...
Read More
An Inside Look at the Outside View
"Generally, people are overconfident when they make forecasts and inexperienced analysts may be less skeptical than they should be." In our latest podcast, Director of Market Strategy Brad Neuman discusses his latest white paper...
Listen Here
Outside View
• Derived from reference class
• Uses evidence from others’ experiences
• Quantitatively grounded
• Can account for unknowns
Click to view an example
The outside view can include an analysis of the amount of time friends have taken to prepare for similar vacations, so it can include unexpected delays.
Making Can Potentially
by Avoiding Psychological
Improve Your Decisions
Russell 3000 Growth Index
Alger Spectra Fund
To begin, please scroll down.
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with sales charges reflect a maximum front-end sales charge on Class A Shares of 5.25%. For performance current to the most recent month end, visit www.alger.com or call 800.992.3863.
Important Disclosures:
The views expressed are the views of Fred Alger Management, LLC. as of April 2020. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security or any funds managed by Fred Alger Management, LLC. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities. Past performance is no guarantee of future results.
Risk Disclosures - Investing in the stock market involves risks, and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. A significant portion of assets will be invested in technology and healthcare companies, which may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. Short sales could increase market exposure, magnifying losses and increasing volatility. Leverage increases volatility in both up and down markets and its costs may exceed the returns of borrowed securities.
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with a maximum sales charge reflect a front-end sales charge on Class A Shares of 5.25%.
On September 24, 2008, the Fund’s name was changed from Spectra Fund to Alger Spectra Fund, and the Fund’s Class N shares were redesignated as Class A shares. The Fund operated as a closed end fund from August 23, 1978 to February 12, 1996. The calculation of total return during that time assumes dividends were reinvested at market value. Had dividends not been reinvested, performance would have been lower. Fred Alger Management, LLC. began managing the Spectra Class A portfolio on December 31, 1974. Class A share since inception returns are calculated from this date.
Only periods greater than 12 months are annualized.
Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.
Investors cannot invest directly in any index. Index performance does not reflect deductions for fees, expenses or taxes. Note that comparing the performance to a different index might have materially different results than those shown. The performance data quoted represents past performance, which is not an indication or a guarantee of future results.
The Russell 3000® Growth Index combines the large-cap Russell 1000® Growth, the small-cap Russell 2000® Growth and the Russell Microcap® Growth Index. It includes companies that are considered more growth oriented relative to the overall market as defined by Russell's leading style methodology. The Russell 3000 Growth Index is constructed to provide a comprehensive, unbiased, and stable barometer of the growth opportunities within the broad market.
Before investing, carefully consider the Fund’s investment objective, risks, charges, and expenses. For a prospectus and summary prospectus containing this and other information or for the Fund’s most recent month-end performance data, visit www.alger.com, call (800) 992-3863 or consult your financial advisor. Read the prospectus and summary prospectus carefully before investing. Distributor: Fred Alger & Company, LLC. Member NYSE Euronext, SIPC. NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE.
More on Behavioral Finance
2
In this three-minute video below, Brad Neuman shares how to apply self-distancing and use the lesson of Solomon’s paradox.
Two women approached King Solomon and each claimed that she was the mother of an infant. King Solomon raised a sword and said each woman could have half the baby. One woman cried out and said she loved the baby too much to see it killed. Rather than kill the baby, she said, the king should give the infant to the other women. The second woman said the king should cut the baby in half. Based on the different reactions from the two women, the king ruled that the first woman was the mother. The wisdom that King Solomon exhibited during the matter became famous throughout all of Israel.
King Solomon's Story
2
Source: Alger, FactSet, from 1/1/96 - 12/31/2018. Class A share performance does not reflect the deduction of the sales charge. Had the sales charge been deducted, the return would have been lower.
Click here for standard performance data.
Emotions often cause investors to make poorly timed buy and sell decisions. Click here to view an example.
8.3%
Actual U.S. Stock Funds' Return
9.7%
Investor Return in U.S. Stock Funds
10-Year Annualized Return
Source: Mind the Gap 2018: Morningstar for 10 years ended March 31, 2018
Traditional finance assumes people are rational, possess objective knowledge and stock prices are efficient. Behavioral finance disagrees. It recognizes that people have cognitive biases, use subjective judgement and project their biases onto investment decisions.
CONFIRMATION
BIAS
AVAILABILITY
BIAS
LOSS AVERSION
BIAS
Representativeness
BIAS
OPTIMISM
BIAS
HERDING
BIAS
Click to view an example
Source: Alger, FactSet, from 1/1/96 - 12/31/2018. Class A share performance does not reflect the deduction of the sales charge. Had the sales charge been deducted, the return would have been lower.
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with sales charges reflect a maximum front-end sales charge on Class A Shares of 5.25%. For performance current to the most recent month end, visit www.alger.com or call 800.992.3863.
Click here for standard performance data.
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with sales charges reflect a maximum front-end sales charge on Class A Shares of 5.25%. For performance current to the most recent month end, visit www.alger.com or call 800.992.3863.
Click here for standard performance data.
President Ronald Reagan is shot.
Reagan secretly sells arms to Iran.
Nuclear meltdown at Chernobyl.
U.S. invades Panama.
Operation Desert Storm.
Asian
financial crisis.
Y2K bug wreaks havoc.
Dot.com bubble
bursts.
9/11.
Operation Iraqi Freedom.
Subprime mortgage crisis.
Hurricane Katrina.
U.S. financial
bailout.
BP oil spill.
European sovereign debt crisis.
Hurricane Sandy.
China devalues
its currency.
Coronavirus
hits the U.S
1980s
1990s
2000s
2010s+
$10M
$1M
$100K
$10K
1980
1990
2000
2010
2020
$3,811,015
$1,089,781
$1,049,122
$196,748
Alger Spectra Fund (Class A)
Barclays U.S. Aggregate Bond Index
S&P 500 Index
Russell 3000 Growth Index
Click on a year below to discover the various crises that may have caused investors to fall into emotional pitfalls despite a pattern of historical long-term gains.
The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted. Performance figures assume all distributions are reinvested. Returns with sales charges reflect a maximum front-end sales charge on Class A Shares of 5.25%. For performance current to the most recent month end, visit www.alger.com or call 800.992.3863.
Click here for standard performance data.
Click on a year below to discover the various crises that may have caused investors to fall into emotional pitfalls despite a pattern of historical long-term gains.
President Ronald Reagan is shot.
Reagan secretly sells arms to Iran.
Nuclear meltdown at Chernobyl.
U.S. invades Panama.
Operation Desert Storm.
Asian
financial crisis.
Y2K bug wreaks havoc.
Dot.com bubble
bursts.
9/11.
Operation Iraqi Freedom.
Subprime mortgage crisis.
Hurricane Katrina.
U.S. financial
bailout.
BP oil spill.
European sovereign debt crisis.
Hurricane Sandy.
China devalues
its currency.
Coronavirus
hits the U.S
1980s
1990s
2000s
2010s+
$10M
$1M
$100K
$10K
1980
1990
2000
2010
2020
$3,811,015
$1,089,781
$1,049,122
$196,748
Alger Spectra Fund (Class A)
Barclays U.S. Aggregate Bond Index
S&P 500 Index
Russell 3000 Growth Index