Investing is a psychology game, not an IQ game.
Research shows human decisions are made with 80 percent emotion and 20 percent logic—maybe 90/10 when it comes to investing.
Why is it so hard to let go of your losers?
As some of you may remember, University of Chicago professor, Richard Thaler won the Nobel Prize in economics last year. Thaler is relatively young by Nobel laureate standards, and his primary field of study (behavioral finance), is somewhat controversial to many in the numbers-driven financial advisory world. The idea that psychological research should even be part of economics has raised eyebrows for years.
So what is behavioral finance?
Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors (both retail and institutional), do not act in a rational manner. Think of the moniker “behavioral” as describing how and why individuals behave the way they do.
As Warren Buffet has explained many times: “Investing is a psychology game; not an IQ game.” Research shows that human decisions are made with 80 percent emotion and 20 percent logic. Some would argue the ratio is now closer to 90 percent emotion and only 10 percent logic.
Take the “disposition effect.” That’s the all-too-common situation in which investors hold on to their losers and sell their winners. It’s one of the main reasons that investors--both pros and do-it-yourselfers underperform--they can pick winners pretty effectively, but they cannot sell their losers.
Our egos are a big part of the problem. Our egos are what drive the emotional difficulty of parting with a stock that you spent so much time analyzing. “How can I be so wrong?” you ask yourself. “Eventually my thesis will prove correct.”
An advisor’s job is to help you manage your behavioral biases during different stages of the market cycle. In this long-running bull market, investors start to get short-term memory lapses. In particular, greed kicks in and investors become tempted to move all their assets into equities. You and your advisor should work together to extract emotion from investment decisions and to mitigate unnecessary risk wherever possible.
Our egos get in the way
Why do we think we are so good at financial decision making when the odds are stacked against us? The simple answer can be traced to ego-- the ultimate roadblock to sound investing. According to Ryan Holiday, media strategist and best-selling author of Ego Is the Enemy, the answer is most often NO.
“One might say that the ability to evaluate one’s own ability is the most important skill of all,” wrote Holiday. “Without it, improvement is impossible. And certainly ego makes it difficult every step of the way. It is certainly more pleasurable to focus on our talents and strengths, but where does that get us? Arrogance and self-absorption inhibit growth. So does fantasy and vision,” Holiday added.
From where we sit at our firm, hubris is prevalent due to the market’s all-time highs; but again human biases are coming into play. The 2008 crisis left us with the biggest investing hangover in modern market history. As a result, portfolio managers are scared to death about missing the next correction instead of the hyper-bullish you usually see around equities when markets are at record highs.
Many of my colleagues believe greed has kicked in, but some investors still can’t shake the nightmare of 2008-09 from their memories. Looking at the question from a different angle, we should ask: “Is the index’s standard deviation higher today?” The answer to that question is yes! That’s why it’s essential to make sure your advisors know about all your changing life circumstances, financial needs and ever-changing concerns. Understanding one’s investment psyche has become harder due to recent market volatility and geopolitical events—threats to the long-running bull market that the media constantly reminds us about.
As valuations continue to rise above the top quartile, many fundamental analysts can’t get their arms around being long. The problem is that they are only measuring the ‘P’ in price to earnings–the ‘E’ essentially stands for emotion.
If you or someone close to you has concerns about the viability of your current investment decisions for the near-term and long-term, please don’t hesitate to reach out. We’re happy to help.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail email@example.com.
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