Investing Psychology Chapter 5 Part 2: Corporate Bias, IPOs, and Hidden Trading Costs

We continue with the second half of Chapter 5 from Tim Richards’ “Investing Psychology.” If Part 1 was about how the professional investing industry takes your money, Part 2 is about how corporations and your own trading habits finish the job.

Let’s go through it.

Marriage and Money

Here’s something you probably didn’t expect in an investing book. Your financial adviser’s relationship status matters.

Research by Nikolai Roussanov and Pavel Savor found a direct link between whether a CEO is married and how much risk their company takes. Single CEOs run more aggressive companies. The same goes for mutual fund managers. Single managers take on more irrational risk trying to stand out from the crowd.

Why? Biology. We take bigger risks when looking for a partner. Men shown pictures of attractive women immediately start making riskier choices. This behavior leaks into investing decisions.

The evidence also says women are less likely to be irrational risk takers in finance. So Richards’ practical advice is pretty simple: for financial advice, look for married men or women. Leave the risk-taking single guys to figure themselves out.

Lesson from the book: The best money managers tend to be older, in a stable relationship, and not trying to impress anyone with portfolio size.

Muddled Modelers

The professional investing world loves computer models. These are simulations of how markets work, used to make investing decisions. Here’s the problem: they assume we can actually model markets accurately. We can’t.

Emanuel Derman, a former quantitative analyst, lists many ways models fail. Wrong assumptions. Bad data. Incorrect usage. But it all comes down to one thing: if you trust a model you don’t understand, you’re trusting that the builders knew what they were doing. Often they didn’t.

The famous Black-Scholes model for pricing options is a perfect example. It tells investors what the “proper” price for an option should be. The weird part? Prices only started matching the model after it was invented. Traders using the model made it work because it made their jobs easier. That’s reflexivity in action.

But then Long-Term Capital Management, cofounded by the model’s creators, went bust in 1997 when markets did something the model didn’t predict. And how can you build a model that predicts the unpredictable?

Lesson from the book: Computer models are only as good as their programmers and users. If someone wants you to use one, make sure they can explain how it works. If they can’t, walk away.

CEO Pay: Because They’re Worth It?

Corporations often work against our interests as shareholders. And it starts at the top, with CEO pay.

Research by Joris Lammers and colleagues showed that powerful people think rules apply to everyone except them. Sound like any executives you know?

The root problem is stock options. The idea is to align CEO interests with shareholders by tying pay to stock price. Good in theory. In practice, Daniel Bergstresser and Thomas Philippon found that companies where CEO pay is heavy on stock options have a high rate of earnings manipulation. CEOs will bend the numbers to hit targets and trigger their payday.

This is not a small issue. Xerox, Enron, Tyco, Waste Management. All guilty of this kind of manipulation. All ended in disaster. And those perfectly “aligned” bank executives in 2007? They had no idea their own companies were about to collapse.

Not every powerful CEO is a disaster. For every Jeffrey Skilling there’s a Warren Buffett. But look for the leader who admits mistakes. Everyone makes them. The dangerous ones are those who pretend they don’t.

Lesson from the book: Be careful with companies where CEOs have massive stock option packages. The temptation to run the company just to hit option targets is too strong for some.

Corporate Madness: M&A

CEOs also get their kicks from power. And nothing says power like buying another company.

The problem? Mergers and acquisitions are often a short-term fix driven by ego. Economist Robert Bruner showed that the main winners from acquisitions are the shareholders of the company being bought. They walk away with a 20 to 30 percent premium.

Some acquisitions work. Bolt-on deals in the same niche can do well. But deals that try to diversify the company into something new? They usually fail. Companies are good at what they do. They’re bad at integrating with companies that do something else.

There’s also an anchoring effect at play. Deals that bid above the target company’s 52-week high are more likely to succeed because the target’s shareholders anchor to that peak price and won’t sell below it. This partly explains why more acquisitions happen near stock market peaks.

Lesson from the book: A large acquisition, especially one aimed at diversifying the business, is a strong sell signal. Most big M&A deals are fueled by CEO egos.

Buyback Brouhaha

Stock buybacks are where a company buys its own shares and retires them. In theory, fewer shares means a bigger slice of profits for remaining shareholders. Good, right?

Not always. Paul Griffin and Ning Zhu found a reliable link between buybacks and CEO stock option plans. The more options the CEO has, the more likely there is to be a buyback. And this happens regardless of whether the buyback actually helps shareholders.

There are times when buybacks make sense. If a company’s stock trades below its real value, buying it back is a smart move. But most of the time, buybacks are just another tool for executives to boost share prices and trigger their own payouts.

Lesson from the book: View big buyback programs with suspicion. Check the executive stock option packages first. It’s usually more about the executives than the valuation.

Oh No, IPO

IPOs are where companies go public for the first time. Richards’ advice is blunt: avoid them.

Why? It’s the lemons problem again. The people selling know way more about the company than you do. If the business is so great, why are they selling?

Jay Ritter’s research shows that IPO’d companies gained over $124 billion in first-day trading between 1990 and 2009. That sounds good for buyers. But the investment banks running the IPO tend to over-allocate stock, leaving buyers chasing it at higher prices in the market.

Then there’s the winner’s curse. In any auction, the winner is the person who paid the most. And the person who pays the most is usually the one who least understands what they’re buying.

Lesson from the book: IPOs pit sellers who understand their business against buyers who don’t. Unless there’s an obvious reason the float is a bargain, stay away. The risk is all on the downside.

Your 6 Percent Self-Inflicted Trading Tax

Here’s the number that should make you stop and think. Private investors lose roughly $170 billion a year in trading stocks. That money goes to corporations, dealers, foreigners, and mutual funds.

Where do the losses come from? Four places: trading losses (a quarter), commissions (a third), transaction taxes, and market-timing mistakes. The main cause? Overconfidence. We trade too much and don’t track our real costs.

UK author Pete Comley estimates that most investors start each year at minus 6 percent. You need to make 6 percent just to break even after inflation and costs. That means most people would be better off leaving money in a savings account.

Lesson from the book: Track your investments and account for your costs. You may be shocked at what you find.

Expert Opinion? Not So Fast

Your doctor, dentist, and lawyer all need proper qualifications. Financial advisers? Not so much. Most rely on contracts rather than a real duty to serve your interests.

The concept of fiduciary duty goes back to medieval times, when knights left trusted advisers in charge of their property. A fiduciary’s job is loyalty and prudence toward clients. Sounds perfect for a financial adviser. But most financial fiduciaries just follow the Efficient Market Hypothesis and deliver average market returns. You could do that yourself with an index fund.

Lesson from the book: If you want a good financial adviser, you need to work hard to find one. Don’t assume fiduciary duty will protect you. Know enough to test their knowledge yourself.

Avoid the Sharpshooters

Feeling alone with your money? Richards has one more warning. Be careful of investment “experts” who sell you their success stories.

The Texan Sharpshooter Effect works like this: shoot randomly at a barn, then paint the target around wherever your bullets landed. Invite friends to admire your aim. Most investing self-help works the same way. They pick examples that “prove” their method after the fact.

Instead, look for people like Phil Fisher, Ben Graham, Charlie Munger, or Warren Buffett. People with long track records who admit their mistakes. They don’t need your money. They’re already rich.

Lesson from the book: Learn from the best investors, not the best self-promoters. Anyone can look good if they set their goals after achieving them.

The Seven Key Takeaways of Chapter 5

1. Incentives matter. If the people you deal with have different incentives than yours, recognize it.
2. The professional investing industry exists to take money from you. You can’t beat it short-term, so don’t try.
3. Both mutual funds and index trackers have a role, but neither is a ready-made solution. Learn the rules.
4. Investment forecasts are modern fortune telling. They’re right until you need them.
5. Prefer advisers who are married, experienced, or female. These are indicators of lower risk-taking, but do your own checking.
6. Watch out for CEO stock options, stock buybacks, and aggressive M&A activity before investing in a company.
7. Ignore self-proclaimed experts relying on the Sharpshooter Effect. Find people with real, long-term, public track records.

That wraps up Chapter 5. The experts and the corporations have their own biases and their own incentives. Mostly, those incentives don’t align with yours. The best defense is awareness and honest self-tracking.

Next up: Chapter 6 Part 1 - Debiasing Strategies.

Previously: Chapter 5 Part 1 - Why Experts Get It Wrong.