During the ‘60s, Peter, Paul & Mary performed a mournful song titled “Where Have All the Flowers Gone?”  In the financial world, one might write a mournful song titled “Where Have All the Bricks and Mortar Gone?”

When R.O.I. meets with prospective clients, a significant negative presumption R.O.I. must over-come in the mind of the prospective client is the humble home office of R.O.I. – or in other words, the lack of the expensive and impressive “Bricks and Mortar” of national broker-dealer offices (and also local competitors’ offices).  You, R.O.I.’s clients, are very helpful in preparing prospective clients whom you refer, to over-come that presumption, and actually turn it into a positive principle because it results in:  lower R.O.I. overhead (i.e., lower costs to clients); more personal attention to you by Grant, Ben and Ron; and, more personal access by you to Grant, Ben and Ron.

Below is a brief history of some of the many, famous, “Bricks and Mortar” national broker-dealers, with whom you have been undoubtedly familiar, who have gone out of (or may go out of) existence, and the basic reasons why:

E.F. Hutton – Scams leading to pleading guilty to 2,000 counts of mail and wire fraud. 1988;

Salomon Brothers – A $290 million fine for false trading led to its acquisition by Travelers Group, who stopped the proprietary trading program and stopped using the Salomon name.  Salomon was also the breeding ground for the founders of the Long-Term Capital Management hedge fund that collapsed in 1998, almost causing a world-wide financial collapse.  1991

Kidder Peabody & Co - A trading scandal related to falsified profits led to its purchase by Paine Webber.  1994

Dean Witter Reynolds – Acquired by Morgan Stanley.  1997

Paine Webber – Unprofitable acquisitions of other brokerage and investment banking firms.  2000;

A. G. Edwards - Acquired by Wachovia Corporation.  2007.

Lehman Brothers Holdings, Inc. – Being a leading cause of the sub-prime mortgage crisis led to bankruptcy.  2008

Bear Sterns – Failure of mutual and hedge funds during sub-prime mortgage crisis resulted in a Fed bail out, but Bear failed anyway for public lack of confidence, and was acquired by Morgan Stanley.  2008

Wachovia Corporation – Risky adjustable rate mortgages during the sub-prime mortgage crisis resulted in a government-forced sale to avoid its failure – purchased by Wells Fargo.  2008

Smith Barney – After multiple previous acquisitions, it was acquired by Morgan Stanley during the sub-prime mortgage crisis in 2008.  Now, Morgan Stanley is dropping the Smith Barney name.  2011

Securities America – State and class action law suits over fraudulent private placements defaults.  Will parent (Ameriprise Financial) spend $200 million to bail-out SA, or will it let SA fail?  2011?

Merrill Lynch – Saved from bankruptcy by Bank of America’s buy-out and then Bank of America’s federal bail-out, in 2008.  ?????

R.O.I.’s business is quite simple = “Taking Care of You”.  You know exactly how, how much, and when R.O.I. is paid, therefore you know what R.O.I.’s financial motivation is for “Taking Care of You”.  You know R.O.I.’s principals, personally and well – those same three guys that are always there for you, and always in the same business.  Most of you have been with R.O.I. for the first two generations – some of you and your future generations will be there for R.O.I.’s third generation. That is stability.  That is comforting.  But there never has been and probably never will be much in the way of expensive and impressive “Bricks and Mortar”.

At some point, the efficacy of investment advice is evaluated by the client.  Individuals sometimes make evaluations that are inconsistent with their well-being, and these inconsistencies can occur in systematic ways.  In some instances, this systemic behavior is driven by:

1. Emotions that lead people astray; and/or,
2. Cognitive failures, that is, people make mistakes.

What are some of the primary emotions and cognitive failures that encumber investment advice evaluation?  In the two prior issues of “Taking Care of You” we discussed:

1. Hindsight Bias = the tendency for people with knowledge of what happened to have an inappropriately strong belief that they would have predicted that outcome.  This occurs because events that the best-informed experts did not anticipate often appear almost inevitable after they occur;
2. Outcome bias = inappropriately taking the known outcome of a decision into account when evaluating the quality of the decision or the decision making process.  This occurs when a decision making process is designed to WORK MOST OF THE TIME, shifting the ODDS TO THE CLIENTS’ FAVOR over the long term, but it is UNREALISTICALLY expected to work in ALL environments over any short period, even though it has been REMARKABLY SUCCESSFUL at producing POSITIVE OUTCOMES.

MYOPIC LOSS AVERSION

Myopic Loss Aversion (MLA) is the tendency for individuals to allocate more weight to losses than to gains of an equal magnitude (e.g., losing $100 hurts more than the pleasure enjoyed by gaining $100).  Various studies have estimated that most people find the pain from a loss of $X to be twice as strong as the pleasure of a gain of the same dollar amount.

Clients with MLA (it sounds like some kind of disease, but it is not – it is just a natural tendency of most of us), evaluate the performance of their equity exposure over inappropriately short periods and will tend to prefer more and more conservative investments that may be inconsistent with what an objective analysis suggests they need.  Because R.O.I. believes that we may be in another (like 2000-2009) Secular Blah or Bear market, R.O.I. has suggested that clients consider moving to a more conservative allocation, unless they need a particular, reasonable, return to reach their goals.

Further analysis reveals that clients with MLA are not aware of it.  This is consistent with the results of many studies on Hindsight and Outcome biases:  individuals committing the error are often unaware. 

A “symptom” of MLA is that clients will have a narrow frame when it comes to performance, i.e., they will evaluate their portfolio over a short period and measure it simply by ending value minus beginning value.  The “cure” for MLA is to focus on:

1. Progress towards a goal, such as growth towards a certain dollar amount; and,
2. Lengthening the evaluation period, avoiding “noise” in the marketplace over the short term.

Then, when there is a downswing – and of course there will be downswings - attention can be constructively placed on what needs to be done to reach the goal by a certain period, e.g., more contributions, reduce expenditures, lengthen the period, part-time employment, more aggressive allocations, etc. 

Of course, Hindsight Bias, Outcome Bias and Myopic Loss Aversion are all related to each other, and because they are natural tendencies, the afflicted person is often not aware of the tendencies.  But “knowledge is power”, and once we have been empowered with knowledge about these tendencies, we can better avoid systemic behavior, inconsistent with their well-being, that is driven by:

1. Emotions that lead people astray; and/or,
2. Cognitive failures, that is, people making mistakes.

EVALUATING INVESTMENT ADVICE (Cont.)

At some point, the efficacy of investment advice is evaluated by the client.  Individuals sometimes make evaluations that are inconsistent with their well-being, and these inconsistencies can occur in systematic ways.  In some instances, this systemic behavior is driven by:

1. Emotions that lead people astray; and/or,
2. Cognitive failures, that is, people make mistakes.

What are some of the primary emotions and cognitive failures that encumber investment advice evaluation?  In the prior issue of “Taking Care of You” we discussed Hindsight Bias.  As a review of that discussion, we repeat in this issue the definition of Hindsight Bias = the tendency for people with knowledge of what happened to have an inappropriately strong belief that they would have predicted that outcome.  This occurs because events that the best-informed experts did not anticipate often appear almost inevitable after they occur.

In this issue of “Taking Care of You”, we will discuss a second emotion and cognitive failure –Outcome Bias.

OUTCOME BIAS

DEFINITION

Outcome bias occurs when one inappropriately takes the known outcome of a decision into account when evaluating the quality of the decision or the decision making process.  Using a doctor-patient study as an example:

1.  Each subject in the first group of the study was informed of:  (a) What the doctor knew (the facts and circumstances of the case and the treatment options); (b) The decision made by the doctor; and, (c) The fact that the outcome was successful.  The subjects were then asked to rate the quality of the thinking that went into the decision;

2.  Each subject in the second group of the study was informed of the SAME things, EXCEPT that the outcome was described as being a failure.

When the subjects were asked to rate the quality of the decision, they were five times more likely to rate the “success” version as having been a higher quality decision than the “failure” version – even though there were NO differences in the known facts and circumstances, the treatment options, and the decisions made by the doctor.  These results were obtained despite the fact that 88 percent of the subjects correctly said they shouldn’t take into account the outcome when evaluating the decision quality given the information known at the time of the decision.

TEST YOUR OUTCOME BIAS

Below is a chart of R.O.I.’s Moderate Allocation’s excess than (+) or less than (-) returns vs. the S&P 500’s returns for the years 2000-2009 (10 years, sometimes called “the lost decade”).  These returns are arranged in a randomly selected (NOT chronological) order, and are then compared against different definitions “of successful decisions”.  Try not to look at the right hand column – DON’T LOOK!!! - until you have studied the chart – you may be in for some surprises.

There is a “trick” built into the above chart – did you catch it?  Neither of the “definitions of successful decisions” are definitions of decisions – instead, they are definitions of results or outcomes – but this is the “Outcome Bias” way our minds and hearts usually work.  Actually, almost the exact same decision making process was used in every of the above years (“almost exactly” because R.O.I. is always trying to learn how to improve, and has periodically made small changes to the initial process). 

The “take away” lesson from this discussion about “Outcome Bias” and evaluating R.O.I.’s decision making process, is that R.O.I.’s decision making process is designed to WORK MOST OF THE TIME, shifting the ODDS TO THE CLIENTS’ FAVOR over the long term, but it is UNREALISTIC to expect it will work in ALL environments over any short period, even though it has been REMARKABLY SUCCESSFUL even if you measure it by RESULTS OR OUTCOMES.