10 ways not to sabotage your financial security

Have you ever wondered why doing the right thing or behaving as we "should" is usually the most difficult choice? Especially when it comes to handling our finances, there is almost always a less emotionally challenging path than the one that is "in our own long-term best interest." We know we should defer that trip to London in order to put more into our retirement account. We know we should wait until we have accumulated the cash to pay for the new sofa or car, rather than putting it on plastic. But we tell ourselves that we deserve it--right now! -- because we have earned it. After all: "Who knows what tomorrow may bring-- As it turns out, there is actually a scientific explanation for such behavior. Blame it on old (psychological) wiring and the fact that--at least from a scientific perspective--we are really not as modern or "evolved" as we may think we are.

Moving at the speed of change

I read somewhere that a single edition of one of today's daily newspapers contains more information than someone living in the 1700s would have been exposed to in a lifetime. Supporting this observation, John C. Bogle (founder of Vanguard Group) points out in his recent book The Battle for the Soul of Capitalism that: "The flourishing of capitalism was central to the soaring prosperity that became the hallmark of the modern era. During the past two extraordinary centuries, the global economy has experienced increasing productivity and economic growth at rates never witnessed before in all human history."

Bogle goes on to quote neurologist William J. Bernstein (The Birth of Plenty: How the Prosperity of the Modern World Was Created): " about A.D. 1000-the improvement in human well-being was of a sort so slow and unreliable that it was not noticeable during the average person's 25-year life span. Then, not long after 1820, prosperity began flowing in an ever-increasing torrent. With each successive generation, the life of the son became observably more comfortable, informed, and predictable than that of the father."

The "problem" with this pace of innovation is that our human brains simply can't keep up; it takes a long time to change how our brains are organized. In evolutionary terms, "a long time" means millennia -- not a mere decade or two. Though our technological environment has reached a tipping point of inventive speed, our brains are still better organized to respond to threats in our native habitat, i.e., the steppes or jungles. This wiring promotes habits, biases, and reactions that may not lead to the most constructive financial choices.

For example, one of the key factors that ensured the survival of our species to date is a finely tuned "fight or flight" response. Those ancestors who formed a committee to decide how to deal with the tiger in the path were short-lived, of course, while those who successfully outran it survived to pass along their genes. Though today we may not deal with life-and-death issues every day, our brains still function as if we do. Scientists have proven (with the help of increasingly sophisticated and advanced imaging technologies like PET scans, EEGs, and fMRIs) that when we are faced with the common stressors of today's daily life -- traffic, long lines, arguments, 300-point Dow declines, April 15th -- our bodies still respond as they have for millions of years: our heart rates increase, we sweat, our pupils dilate, and "stress hormones" like cortisol and adrenaline flood our system. As the bulk of our brain activity is diverted into some of the deepest and oldest parts of the cranium, we become fixated on the issue at hand, often resulting in tunnel vision. So much for "modern man" or rationally acting "homo economicus"!

In the financial and investment arena, our mental wiring often produces fiscally imprudent initial reactions. For example, sound, long-term investment decisions often require us to make choices that run counter to near-term prevailing wisdom or consensus thinking (such as selling when markets are frothy or buying when there's "blood on the Street")--but we are social creatures at heart, and most comfortable when we fit in. We crave predictability and control over our environment--but the markets are unpredictable and random. We infer short-term "patterns" reinforced by what we just read in the papers--but refuse to recognize long-term sea changes that evolve through many subtle nuances. We love to share stories--but often find it overwhelmingly challenging to grasp complex financial and mathematical relationships. And we are irresistibly drawn to what is happening in the here-and-now--often refusing to focus on what may or may not come to pass in the future.

We are not obligated to be our own worst enemy, however. Neuroscientists are learning that, contrary to popular myth, losing brain function as we age is not inevitable. We can actually retrain and strengthen important neural pathways (i.e., the way we think and process daily events) throughout life by learning new skills or teaching ourselves to approach problems from a different "angle." The first step is to admit that we are all compelled to "misbehave" when it comes to our own financial well being, and then commit to taking a different course of action. This quarter's column will outline, in the style of that famed late night talk show host, the "Top 10 Ways We Sabotage Our Financial Well Being." Next quarter's column will focus on strategies and tactics for setting yourself on sounder fiscal footing.

#10 We won't stop running with the herd

Neuroscientists have discovered that the part of our brain that registers reaction to being picked last for the team or excluded from the hottest party in town is the same area that registers physical pain. In other words, we feel intense social and physical "disconnect" if we are not part of the crowd. In prior days of jungle- or cave-based existence, our species' very survival depended upon our ability to run as a pack. In the modern investment arena, however, our "survival" can depend upon an ability to think and act independently. The old adage that the market vacillates between greed and euphoria is true (just think back over the past 10 years and recall the greed from 1996-1998; the "Asian Contagion" in 1998; the tech bubble culminating in 2000 and then bursting in 2002-03; the market rebound from 2003-06; etc). Allowing yourself to get caught up in herd euphoria or depression is essentially allowing "mob rule" to overrun your investment plan.

#9 We can't separate money and emotions

Most people will readily admit (at least to themselves) that money is a highly emotional topic. In fact, some of our earliest memories likely carry positive or negative financial overtones. Buying penny candy at the local store; the satisfaction of the first cash earnings from a paper route; Grandma tucking a dollar bill into your pocket and whispering "Let's keep this between us"; or being made fun of because your clothes were not designer label--all of these experiences imprinted important emotional messages on our psyches. For those who have spent a lifetime of sacrifice and hard work building a pool of investable assets, emotions are a vital consideration in planning for investment and stewardship of funds. In fact, neurologists and psychologists have learned (by studying individuals who have sustained damage to the portions of their brains that register emotion), that it is nearly impossible for us to make wise choices about risk without engaging our emotions. Even if rooted in sound financial, investment, or tax theory, decisions that do not allow us to sleep at night are rarely worth the emotional toll they extract.

#8 We are more easily influenced by context than content

In selecting asset allocation targets or individual investments, the primary consideration should be valuation relative to prospects (as measured by earnings, book value, cash flow, etc). In essence, you should evaluate the business or industry for long-term merits just as a banker, creditor, or owner would--you are not buying a lottery ticket. Despite the logic of taking a measured approach to investing, our investment decisions are all too easily influenced by what we have most recently read or heard.

As previously mentioned, behavioral scientists have shown that humans are naturally inclined to want to be in synch with the rest of the crowd. This is why it can be so very difficult to ignore the pull of the media. We think that "if it is in print, it must be true." But media stories often are created to generate audience interest and please advertisers--not to reassure us about the soundness of our investments. Becoming too negative on the broad market or on certain classes of investments when all of the headlines are proclaiming doom can prevent some folks from initiating or continuing to make wise investment choices, compelling them, for example, to sit on the sidelines or to sell precisely when they should be buying.

In March 2000, for example, when record amounts of money were flowing into the stock market despite valuation levels many multiples above any previous norms, the headline on Fast Company magazine read "The Battle for the Soul of the New Economy. Built to Flip. Forget 'Great Companies'--Get Rich Quick!" This is not exactly a message that imparts temperance. Just two years later, in the late summer of 2002, just as the markets were hitting their lows, Time proclaimed "Will You Ever Be Able To Retire-- above a garish cartoon of a roller-skate-wearing granny carhop. The same week, BusinessWeek had a roaring bear on its cover, accompanied by the caption "The Angry Market--Can You Afford to Retire-- in large red letters.

#7 We can't think long-term

As if we didn't already know it, neuroscientists have shown that when faced with a choice of "now" versus "later," most of us choose now. In one classic study, respondents were asked if they would prefer $10 today or $11 tomorrow. The bulk chose "today." Oddly enough, though, when asked if they would take $10 in 365 days or $11 in 366, the bulk of respondents chose to wait the extra day. I suspect that part of the reason for this is that "today" and "tomorrow" are both palpable, near-term time periods. But when looking out a year or more, one day seems as remote as another. An ability to move beyond this "future fuzziness" syndrome, however, is vital to grasping important long-term investment concepts such as compounding (which Einstein, incidentally, labeled the most important formula of all).

While compounding may seem dull in the early stages, the bottom line advantages can be startling once the balance starts to grow. For example, take two different 30-year-olds and their retirement savings plans. The first saves $1,000 per year for the first 10 years and then does nothing for the next 20. Assuming a compound annual increase of 8 percent, the first individual invests a total of $10,000, which increases to $72,923 by year 30.

The second individual does nothing for the first 10 years and then saves $1,000 per year for the next two decades, in an attempt to try to catch up. As the table shows, the second individual invests twice as much of his own capital ($20,000 versus $10,000), but ends up with a substantially smaller pot simply because of the fact that he had a shorter time frame in which to compound money. (Space prevents me from supplying the complete table here, but e-mail me if you are interested in seeing it--it's even more compelling!)

#6 We live in Lake Wobegon, where all the investors are above average

I've heard that when surveyed, the vast majority of drivers label themselves "above average." Now, I commute nearly 100 miles each day on a major interstate, and I don't know where all those above-average drivers are hiding, because I don't see many of them on my route. This tendency to be overconfident in our ability carries over into the investing world as well. Despite the fact that many long-term studies show that only a small minority of actively managed mutual funds consistently outperform their benchmarks, investors continue to pour money into actively managed funds, presumably assuming that they are smart enough to choose (and stay in) the outperforming "exception." In reality, individuals have a poor track record of making choices not only about which funds, but about their investment timing. Vanguard's John Bogle cited some telling statistics in a recent speech. He calculates that between 1984 and 2004, the average market index grew 13 percent per year, but that the average mutual fund grew an average of 9.9 percent per year. Owing to poor timing decisions--buying high and selling low--the average fund investor actually generated a return of 6.6 percent. Morningstar, the mutual fund rating company, has recently implemented dollar-weighted return statistics for a number of the funds in their database that also attempt to measure investors' timing decisions; their information corroborates the figures pulled together by Bogle.

#5 We are always "lookin' for risk in all the wrong places"

In ancient days, our survival depended upon being able to recognize patterns and respond appropriately: being able to avoid mud pits, poisonous plants, or snake lairs, for example. Our brains seek patterns and order--even in places where none can exist. This can be especially detrimental in the investment arena, since markets themselves are inherently random. The popular media is rife with articles predicting the market and the economy's next move, as if an accurate prognostication would yield an investable event. Even if you can figure out what the economy is going to do, you can't know how individual stock prices or even broad sectors will react to events--since pricing is an aggregation of the individual decisions of many different participants with different goals. If one could influence or accurately predict such movements, it would probably be illegal. (Just ask the Hunt brothers, who cornered the silver market back in the 1970s; or more recently, former Enron energy traders). Falling into the fantasy that we can accurately predict market movements can lead us toward trying to "time" entry into or out of specific asset classes--which, as we've seen, we're not very good at.

#4 We ignore risks over which we have some control

While you can't control performance, you can control your costs, your taxes, your asset allocation, and the frequency with which you readjust, reassess, or rebalance your asset mix. You can control how your estate plan is drafted, how much insurance you carry, how fiscally educated your family members are, and your business succession plan. Spend your time getting and keeping a handle on those factors and you won't have time to fret about headlines or market predictions of gloom or greed!

#3 We want it all

Whether or not we admit it, we all want a guaranteed investment that has big growth, big yield, zero downside, and the ability to sustain hefty withdrawals--all while outperforming whatever major index is the measure of the day. While it seems obviously silly when these goals are set out in print, many of us do look for a single investment to do it all. Just as we need more than a single club to complete a round of golf, however, we cannot rightfully expect one investment to accomplish all of the goals of a financial plan. Some investments are for growth, some are for income, and some are for insurance. Appropriately mixing them for various life stages is as much art as it is science.

#2 We at least want more than the Joneses

On top of all the other things that we want our investments to do, we also want them to give us bragging rights. Keep in mind, though, that for every "I made 20 percent last year in XYZ Widget" story you hear at a cocktail party, there are likely to be just as many (if not many more) tales of gruesome blow-ups or investments gone seriously awry. It's human nature to want to pass along only the stories that put your investment prowess in a favorable light. When was the last time that you heard someone say, "I made this really incredibly stupid investment last year and lost my shirt"? But someone had to have owned all those imploding Internet stocks, right?

The unfortunate thing about being exposed to the "I made a killing" stories is that they can lead you to think that your investment choices are inferior or that you are not as smart or well-positioned as your friends, neighbors, or co-workers. Further, each bit of this type of information prompts our brains to want to take some sort of action--and action taken in this context is more likely to be an emotionally based reaction, rather than a thoughtful plan that considers our unique needs.

#1 We forget there's more to life than money

Given both our innate wiring, and society's deification of capitalism, it is very easy to get caught up in the "money rat race" and forget that there is so much more to life. While a well-padded bank account does make paying the bills easier, money can also bring a host of concerns and a variety of complex planning and transfer issues--especially when families are involved. Because money and emotion are inextricably entwined, it is not surprising that money can be the cause of heartache, ill will, and family discord. One of my favorite cartoons shows a portly gentleman at the gates of heaven with bagfuls of money tucked under each arm. St. Peter is at the gate, keys in hand, informing the man: "And I happen to know they won't let you take them with you down there, either." Seems we would all do well to bear this in mind!

Carol M. Clark, CFA, is a partner and investment principal of Lowry Hill Private Wealth Management, a 20-year-old firm offering comprehensive investment and financial management services to more than 300 families from its offices in Minneapolis, Scottsdale, Ariz., and Naples, Fla. Prospective clients are willing to invest at least $10 million.