Understanding the gap in what we know we should do and why we don’t do it is essentially known as behavioral finance. Having had many economics classes I have been puzzled at what some people call what a rational person would do. And who is this rational person? Harry Markowitz a Nobel prize-winning economist didn’t follow the rational side of what his own research showed that others should do. Fortunately, people like Daniel Kahneman, Richard Thaler, Schlomo Benartzi, Dan Ariely, and Daniel Crosby have studied more on why we don’t do what we should do. Dr. Crosby writes:
“We as investors are always searching to make the best investment possible, to beat the market and try and secure for ourselves untold fortunes in the process. What few understand though is that all along the way, we are subject to emotional traps that make this difficult for the average investor and we actually end up doing much worse than average. For the twenty years ending 12/31/2013 the S&P 500 averaged 8.21% a year but the average equity investor earned a market return of a mere 4.25%. This emotion-fueled gap between market returns and investor returns is often the difference between being able to retire or not…”1
Behavioral Finance and Beyond Fear and Greed
Let’s look at the state of Illinois’ pension woes. Pension funds typically use professional Actuaries and institutional money managers. Surely these people with all of their knowledge would do the rational thing in managing the pension. However, that is not what happened. Few people enjoy the act of saving. It is often perceived as a loss of what you could do with the dollars today. Politicians have their constituents demanding funding for today’s needs and desires. Saving money for those who are delivering services is not a priority to these people.
Rather than saving more and assuming a more conservative rate of return why not target a higher rate of return and save less? Do you prefer to spend money today rather than save it for something in the future? Unfortunately, Illinois’ hoped-for rates of return did not happen. I would argue that those hoped-for returns were highly improbable and came with their own level of risk. Wouldn’t a rational person understand the risks and have a backup plan Have you calculated your own risks such as investments, losing your job, becoming disabled, etc.?
Daniel Kahneman’s book “Thinking Fast and Slow” changed my life. Essentially he says that there are times when we need to slow down and think more rather than react or jump to conclusions. There are other times when reacting is a positive thing. Knowing when to switch from one thought process to another is key.
Behavioral finance and following the herd
Herd behavior is when we follow the crowd. Often there’s comfort in being in the pack. There’s even a song lyric “I’m in with the in crowd”. Companies know this and often advertise that they are the number one in their category. They hope that you will find it comforting to be in the “in crowd”. Have you done that? Do you know if the crowd is right? In “The Poseidon Adventure”, one of my favorite movies, the eventual survivors tell several passerby why they are going the wrong way. However, those passerby decided not to listen to logic but to follow the crowd to their peril.
Behavioral finance and recency bias
We often focus on recent events. Ebola has been replaced by ISIS (ISIL). We tend to overweight what has happened to us recently. When the market is good we tend to believe it will continue forever. When the market is bad we tend to believe that it will be bad forever. When looking at investments many people tend to look at what has happened recently. As a qualified investment advisor representative investment companies regularly try to sell to me in an effort to sell to you. Often I hear we were a top performer in the last 12 months. Should I run and tell my clients about this fact? Does that indicate luck or skill? What evidence do I have that overperformance will continue?
I know that if I flip a coin 10 times I may get 10 heads in a row. However, I know that the probability is 50-50 and that if I continue flipping the coin long enough it will come back to that average. If it does not I know that there have been some shenanigans going on with the coin. Should I mention Bernie made off at this point?
How can you use behavioral finance to your advantage?
Let’s start with helping you to save. Are you saving enough for your retirement? Are you saving enough for your other goals? Do you have plans in place if you’re unemployed, disabled or a key family member is the tragic car wreck story on the evening news? One of the ways to deal with the perceived loss of savings is to couch it in terms of getting other raises. You might get a raise at work and rather than spend it all you could save half in your 401(k) and spend half. As you pay off debt, rather than thinking of that as free cash flow, why not take half of that savings and put that towards getting life or disability insurance to hedge against those risks?
Daniel Kahneman, who won the Nobel Prize for behavioral finance offers his personal way to deal with the perils of his nerves surrounding investing. In his book, he quantifies the costs of trading too much in reaction or overconfidence. We typically buy low and sell high which is costly. His answer is to not look at his quarterly statement.
If you have ever seen one of those long-term results for the stock market since the Great Depression its long-term average came from not doing anything other than staying invested for the entire time in the S&P top 500 US companies. Averages have their ups and downs. Have your stock investments done better?
We look forward to learning more about your situation and seeing how incorporating behavioral finance into the building of your financial plan might help you achieve your goals. Connect with us here!
1The World Needs Your Weird, inkblot.com, May 5, 2014
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested directly.