Brandes Quarterly Letter: Guarding Against Natural, Built-In Biases

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1 Brandes Quarterly Letter: Guarding Against Natural, Built-In Biases April 5, 2019 by Team of Brandes Investment Partners Our thought leadership division, the Brandes Institute, routinely writes about biases that can derail even the best investment strategy. Cognitive biases such as anchoring, confirmation and survivorship are natural, built-in biases that can cause real damage if not identified and guarded against. We recommend establishing rules and guidelines to help investors manage innate biases. One effective resource we developed with behavioral finance expert Dr. Frank Murtha* is the Investor Stress Management Plan. This tool is designed for use by individual investors and plan participants. The idea is for them to describe in their own words the actions they will take, for example, during a market correction. By identifying logical responses before a stressful event happens, investors may feel a greater sense of control when one actually occurs because they knew it would happen and how to respond. On the theme of behavioral biases, two items caught our attention over the past few months. The first, which on the surface is unrelated to investing, provides a history lesson on how the U.S. armed forces sought to protect combat planes during WWII. 1 The second item, which is more directly related to investing, pertains to the largest cohort of professionals in our industry: 25 to 34 year olds. This group has never experienced a period in which value stocks outperformed their growth counterparts. Why do we think these seemingly unrelated items offer important insights for today s investment professionals in spotting and dealing with behavioral biases? Page 1, 2019 Advisor Perspectives, Inc. All rights reserved.

2 In an effort to help reduce damage from enemy fire, the U.S. military decided to armor its bombers and set out to determine the most efficient way to do it. They rigorously analyzed what they thought was all available data and produced a diagram indicating where the planes were sustaining the greatest damage. The theory was straightforward: Reinforce the areas with the most red dots (see corresponding image). However, the engineers succumbed to what has come to be known as survivorship bias. 2 This is the tendency to focus on the available data and ignore failures which may have reduced the size of the sample. The engineers failed to recognize the obvious the areas on the planes that sustained no damage were actually the most vulnerable. Why is that? Most of the planes that suffered hits to areas not marked by red dots the nose, engines and mid-body never made it home and were thus omitted from the sample. Therefore, the original conclusion on where to strengthen the planes, based on those that returned home, failed to consider all evidence. With greater insight, the engineers would have realized that they did not include all relevant data before they drew their conclusions. In the second item, a research report from Bank of America, we learn that, The largest age cohort of financial services employees is now 25 to 34 year olds (Source: BLS). The most memorable early event of their careers was likely the Financial Crisis. Growth and momentum stocks have outperformed for their entire careers, whereas value investing has been a losing proposition. The average level of the VIX (the CBOE Volatility Index) since they began working is 17, ~25% lower than the prior two decades average of Page 2, 2019 Advisor Perspectives, Inc. All rights reserved.

3 One need only look at the longer term (see table) for evidence that young investment professionals may be suffering from attention response (also knowns as recency bias), which is the tendency to incorrectly estimate the frequency or severity of an event based on recent exposure to it. 4 As value investors, we believe it s plainly evident that company valuations (the basis for value investing) have always mattered, surely matter today, and will matter in the future. The Bank of America report puts it succinctly (with emphasis added): The prototypical professional investor is likely focused on growth and momentum, thinks Financials are un-investible, is unused to volatility, and sees valuation as largely irrelevant. 5 We worry that such biases will lead to disappointing long-term outcomes. So, how to deal with these behavioral biases? We recommend looking beyond the immediately available data, broadening your time horizon beyond recent periods and challenging your prior conclusions especially those that feel the most comfortable. Given the natural tendency to generalize based on recent events (e.g., the period subsequent to the Global Financial Crisis), we encourage investors to consider a larger sample set (i.e., by including pre-crisis data) and focus on the bigger picture to avoid repeating possible pitfalls these biases can create. For more information on how to address biases in decision-making, or for additional details about how Brandes seeks to exploit these biases in the marketplace, please contact us. *Frank Murtha, Ph.D., co-founder of MarketPsych, specializes in helping others apply behavioral finance theories to enhance decision-making with the goal of improving returns. He has consulted to dozens of leading financial institutions and trained thousands of professionals. Dr. Murtha is not affiliated with Brandes Investment Partners. 1 Abraham Wald and the Missing Bullet Holes, Jordan Ellenberg. An excerpt from How Not To Be Wrong, Penguin Press, as published by Medium, July 14, One Man Explains Why WWII Aircraft Were Protected The Wrong Way, And It s An Important Example Of Survival Bias, By Rugile, BoredPanda Staff, Undated, boredpanda.com. 2 3, 5 "Critical Thinking Survivorship Bias, deadwildroses.com, March 18, US Equity Strategy in Pictures Two themes drive our calls, Bank of America Merrill Lynch, January 30, 2019, p From: brandes.com/us/advisors/training-the-investor-brain/behavioral-biases/attention-response. Source: Andreassen, P. B. (1990). Judgmental Extrapolation and Market Overreaction: On the Use and Disuse of News. Journal of Behavioral Decision Making. 3: doi: /bdm Page 3, 2019 Advisor Perspectives, Inc. All rights reserved.

4 The MSCI World Value Index with gross dividends captures large and mid cap securities across developed market countries exhibiting value style characteristics, defined using book value to price, 12- month forward earnings to price, and dividend yield. The MSCI World Growth Index with gross dividends captures large and mid cap securities across developed market countries exhibiting growth style characteristics, defined using long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or retrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an as is basis and the user of this information assumes the entire risk or any uses made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the MSCI Parties ) expressly disclaims all warranties (including without limitations, any warranties of originality, accuracy, completeness, timeliness, noninfringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages ( The CBOE Volatility Index is a market estimate of implied (expected) volatility that is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes. More specifically, the VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index. There is no assurance that a forecast will be accurate. Because of the many variables involved, an investor should not rely on forecasts without realizing their limitations. The recommended reading has been prepared by independent sources which are not affiliated with Brandes Investment Partners. Any securities mentioned reflect independent analysts opinions and are not recommendations of Brandes Investment Partners. These materials are recommended for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Past performance is not a guarantee of future results. No investment strategy can assure a profit or protect against loss. Brandes Investment Partners does not guarantee that the information supplied is accurate, complete or timely, or make any warranties with regard to the results obtained from its use. Brandes Investment Partners does not guarantee the suitability or potential value of any particular investment or information source. The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors Page 4, 2019 Advisor Perspectives, Inc. All rights reserved.

5 discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Market conditions may impact performance. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility. One cannot invest directly in an index. Past performance is not a guarantee of future results. The foregoing reflects the thoughts and opinions of Brandes Investment Partners exclusively and is subject to change without notice. Brandes Investment Partners is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada. Copyright Brandes Investment Partners ALL RIGHTS RESERVED. Brandes Investment Partners is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada. This Website may also contain trademarks of other companies. Page 5, 2019 Advisor Perspectives, Inc. All rights reserved.