I've noticed in several of my recent client meetings that the topic of risk is being discussed more often. I think this is a good thing. Unlike Chris Lee's article in this newsletter which discusses large, geopolitical economic risks from around the world, I want to concentrate on risks closer to home, specifically individual self-inflicted risks.
Behavioral finance which is a relatively new field of study can help us make better decisions which allow us to reach our financial and life goals. Behavioral finance attempts to understand the biases of human behavior when it comes to money. Imagine economist Adam Smith got together with psychoanalyst Sigmund Freud and combined their two fields of study!
A quick review shows the economy continuing its slow but steady ascent. The economic output grew at a 3.1% annual rate in the second quarter, slightly stronger than previously thought and marking the best growth in two years according to the US commerce department. Unemployment remains low and the stock market as measured by the S&P 500 is up 12.5% year to date according to the Wall Street Journal. Also worth noting is that markets have generally been calm this year. The VIX, or volatility index listed on the Chicago Board of Options Exchange (CBOE) has mostly stayed in a very narrow range indicating little expectation of future volatility.
The above information can lead to what behavioral scientists call anchoring and availability bias.
Availability bias causes investors to be strongly influenced by what is personally most relevant, recent or traumatic. Anchoring causes us to focus too heavily on one piece of information when making decisions. So if the one piece of information we're focused on is the fact that the market has gone up 12.5% this year, our bias will be that this trend will continue into the future.
Mutual fund company, Franklin Templeton, conducted a survey of investors about expected return over a five-year period. The median response was that survey participants expected an annual return of 8%. After being presented with a hypothetical market return of 20% per year and asked the same question about the next five years, survey participants increase their expectation to 15%. The same biases work in reverse too. In 2008 during the Great Recession, the stock market was down 37% as measured by the S&P 500. In 2009 the S&P 500 rebounded with a return of 26.5%. In 2010 the investors survey conducted by Franklin Templeton, fully 2/3 of participants thought the market for 2009 was down or flat. Obviously we are strongly influenced by most recent events and we tend to anchor our perceptions to market highs and lows. This sets us up for unrealistic future return expectations which cause us to make investment decisions based on perception, not facts.
In his recent book Misbehaving, University of Chicago Booth School of Business professor and 2017 Nobel Prize winner, Richard Thaler, thinks loss aversion is the most damaging behavioral bias. Losses have about twice the emotional impact of an equivalent gain. Fear of loss can inhibit appropriate risk taking, such as investing part of your long-term assets in stocks. The stock market has a history of providing much higher returns then investing in bonds and money markets. However, stock prices fluctuate more, producing greater risk of losses. Loss aversion can prevent investors from taking advantage of the long-term opportunities in stocks. When the stock market takes its normal and inevitable step back, investors often react by flocking to cash or money markets. As the chart below shows the average money market account yield with and without inflation adjustments since 2000 has been extremely low. While I feel money market accounts are appropriate for a portion of anyone's portfolio and provide a more secure and liquid investment option, they also will expose us to purchasing power risk. Purchasing power risk is caused when prices of goods and services increases over time.
Another damaging investor bias is overconfidence. Most people think they are above average, whether this pertains to investing or other areas of our life, including our driving ability and our children's accomplishments. Overconfidence in investing will result in people trading too much and diversifying too little. This can also lead to investing during what appears to be a bubble, thinking they can get out faster than others. As a side note, men suffer from overconfidence in investing more than women. Of course women know this already!
Herd behavior or following the crowd is quite common. Investors face strong temptations to join the bandwagon based on emotion rather than a sound financial strategy. Following the crowd by buying a hot stock or buying real estate at inappropriately high levels, and conversely panicking by selling into a market drop, can lead to devastating long-term financial results.
Mental accounting is the tendency of people to designate money for certain purposes. For some, money in a low interest savings account or even stashed in a jar is only for savings. This means they cannot use it for the more financially sound purpose of paying down debt at 15 or 20% interest.
The goal of behavioral finance is to make better investment decisions which allow us to reach our financial and life goals. Most of us know that at some level we suffer from self-control problems but we underestimate the extent of their consequences. Whether it's thinking we can stop for just one beer on the way home, a small piece of cake won't matter to our diet, or we can save more by cutting back on unnecessary expenses only to find that our credit card balances are still increasing, the best way to deal with the biases we understand from behavioral finance studies is to be self-aware and preemptive. Avoid buffets when possible, don’t stop for the first drink, put the alarm clock on the other side of the room so you can't hit the snooze button, and sign up for your 401(k) and increase it automatically on an annual basis.
To be successful we don't have to be correct on every decision we make overtime, we just need to avoid most of the normal mistakes that the average investor makes.
