Falling in Love Can Cost You Big Time

I just read a really interesting article in Financial Advisor magazine, “Don’t Fall in Love with One Player: Behavioral Finance Lessons from the NFL Draft” by Lorie Konish. She explores how Richard H. Thaler, the world renowned professor of behavioral science and economics at the University of Chicago Booth School of Business and co-author of the new bestseller Nudge, has investigated his hunch that NFL teams so overvalue picking early in the draft that they end up paying too much for their top draft picks. As it turns out, Thaler finds that emotions can botch NFL draft decisions in the same way they can harm your investment decisions.

Konish reports from the Investment Management Consultants Association’s (IMCA) annual conference. There, Thaler discussed how, in order to get the second pick in this year’s NFL draft, the Redskins sacrificed their first round pick next year, their first round pick the following year, and their second round pick this year. According to Thaler, because the team gave up so much to secure the number two pick this year, the Redskins likely will be more than willing to pay a “huge price” for their top pick, quarterback Robert Griffin III (RG3), the Heisman Trophy winner from Baylor University.

According to Thaler, it’s not a smart strategy to pay to move up in the draft. In fact, he says, teams would be better off, financially at least, if they traded down. In fact, Konish reports that Thaler, who already advises one NFL team on its draft decisions, noted at the conference that teams that trade a third round pick for a second round pick this year will pay an interest rate for advancing that one round of 176 percent.

“These football team owners are all billionaires,” Thaler said. “I think it’s safe to assume that they didn’t get to be billionaires by borrowing at 176% rate of interest. But they’re so desperate to win that they get emotional and fall in love with a player.”

Teams fall in love with players the same way investors fall in love with stocks. The Redskins, who pulled out all the stops to get RG3, may overpay their new quarterback and consequently negatively impact the team’s future financial health. Similarly, individual investors, moved by headlines touting the hot stock of the moment will often overpay for the stock and later steadfastly ignore any bad news about their favorite company in the same way loyal sports fans stick by their favorite players. Watching our behavioral tendencies play out on the field may make them easier to spot and correct in our portfolios.

Are You Wearing Blinders?

You’ve probably heard a family member or a colleague complain about someone who “hears only what he wants to hear.” While being wedded to one’s opinions and ignoring new, relevant information is human nature, this trait can seriously jeopardize investment decisions. In fact, in the world of behavioral finance, ignoring information that could challenge an opinion you already hold has a name--confirmation bias. When we selectively filter information and focus only on data that supports our current opinions, we lose perspective and are prone to make poor investment decisions. In fact, studies show that even professional fund managers are more likely to accept information that supports their original investment thesis than they are to search for information that contradicts their views.

How does confirmation bias affect your decision making? Think of times a stock you purchased fell in value, yet you remained convinced of its long-term viability. How long did you hang on, expecting it to recover, before you cut your losses? Consider, too, how many investors believe they should only invest in dividend paying stocks. When they see a magazine headline promoting the benefits of dividends, they buy the magazine and read the article to support what they believe. Because they don’t consider the fact that many of today’s dividend paying stocks were not dividend payers earlier because of their startup nature is absent from their decision making process. They don’t consider that selecting only dividend paying stocks over the last few decades would have deprived their portfolios of the returns of companies like Cisco, Kohl’s Oracle, St. Jude Medical, and Starbucks in their early days. Take these factors into consideration and it’s likely an investor will embrace a broadly diversified strategy that includes both dividend payers and non-dividend payers and enjoy the potential rewards of both.

As Benjamin Graham said, “The investor's chief problem--and even his worst enemy--is likely to be himself.” So, be mindful of your behavioral tendencies and keep an open mind. Increased self-awareness can lead directly to better investment decisions.