Strategies to circumvent the fact that we are not very wise investors
By: By Carol Clark | 1,284 Reads
As highlighted in last quarter's Investment Insights column, most of us are not particularly suited to be wise investors. In fact, neuroscientists are increasingly proving what veteran investors and asset managers alike have long suspected: Individuals make a lot of not-so-rational choices when it comes to dealing with their money, investments and financial affairs.
We buy because the markets are hitting new highs; we don't want to miss out, irrespective of underlying company fundamentals. On the flip side, we sell when the headlines are bleak - even if security valuations are already priced to accommodate even more gruesome economic news. We trust our BMW-driving neighbor's "tip" about which hedge fund to buy, regardless of our own risk profile. We are easily influenced by what we have just read or experienced, yet have difficulty working our long-term financial plan.
We regularly revise history and our part in it, assigning blame to others for poor results while assuming successful decisions were the sole result of our own brilliance. We underestimate (or discount entirely) the impact of emotions on our decision-making process and constantly seek historical patterns that fit current situations so that we might better project the future. We seek predictability and stability where none can exist. We look for guaranteed rates of return, "sure things," and to make a quick buck. We are much more comfortable doing what everybody else is doing, rather than charting our own path. In short, we comport ourselves in a fashion diametrically opposed to the rational risk-and-return balancing behavior that economists expect us to display.
As revealed last quarter, this behavior can be traced to the fact we are really not all that "evolved" (at least in developmental terms). The most primal of our instincts - the urge to fight or flee - still typically represents the initial and most potent reaction to stressful or uncertain environments. And what more stressful or uncertain an environment do most of us experience than the investment, financial and business world? While our hard wiring does not leave us innately well suited to be wise investors, all hope is not lost. Some of the most interesting research coming out of brain science labs in the past few decades has revealed that we are "trainable."
True, it takes time and effort to change our thought processes and reactions. But it can be done. In a process not unlike "cognitive therapy," we can teach ourselves to respond differently and more thoughtfully to complex situations. In much the same way that elite athletes envision success, a variety of techniques can be used to help frame issues, sketch desired outcomes, and detail risks as well as potential rewards in the financial management arena.
Visualize Success, Then Commit it to Paper:
A little upfront time spent thinking about the big picture - viewing the scene from 10,000 feet and 10 years into the future rather than right now from 10 inches away - can create an important touch stone for guiding you toward long-term success. Take the time to think (big picture and long term) about what you want your money/finances/portfolio to allow you to do, be, or have. Obviously, this does not simply entail physical assets (e.g., a 48-foot boat or a vacation home in Hawaii) but includes more subjective goals like "I need my portfolio to generate $350,000 per year in income for the next 30 years," or "I want to pay off all mortgages, and fund my grandchildren's education at Ivy League schools." In other words, when friends and family give your eulogy, what message do you hope to leave behind?
It can't be overemphasized: Don't just think through your goals, write them down and refer to them often. When headlines are heavily promoting greed or fear (We know they always seem to be traversing a pendulum between these two extremes.), it is extremely helpful to be able to retrieve your long-term goals and remind yourself of what you are trying to accomplish. Carry them in your pocket, so you can "touch" them when you are tempted by a golfing buddy's tale of excess riches from a single investment.
Mindset is a Choice
It's been said that great fortunes are typically not made in the markets. Rather, significant personal and family wealth are more often successfully reaped over time by building or running a business or by success in a craft or skill. This is a subtle but vitally important statement. Many approach the markets (especially the equity markets) as if they were buying a lottery ticket or rolling the dice, assuming just one "lucky" purchase will put them on the road to fortune. Clearly, a flawed approach at best. The key lies in developing an alternative mindset and corresponding investment program to retain the capital invested, balance a variety of risks pertinent to your individual situation, and keep your purchasing power ahead of inflation over a long time period. Put simply, it's a choice to behave like a rational, discerning, financially astute adult or more like a hormonal, emotional teenager.
Understand Pertinent Risk
Like beauty, risk means different things to different people. Further complicating the issue is the reality that risk comes in many different forms. As an example, there is broad market risk when investing in stocks as a category, since they have the potential to markedly fluctuate in price daily. This risk can actually be compounded if your equity investment is concentrated in a single security. Since you don't have control over the public market's collective perception of a company's worth, this even holds true for those stocks very familiar to you (e.g., the company you work for or own).
Market variability is often the only risk that most people consider. However, there are much larger risks over the long haul, such as loss of purchasing power (i.e., the fact that $1 today buys $0.97 worth of last year's goods). An expensively managed portfolio - one high in fees, turnover, or taxes - can also represent a pertinent risk and a drain on your ending net worth. Inelegant tax or legal advice, especially as it relates to your estate or philanthropic intentions, can fuel problems (including ill will directed toward you) that last for years.
Outline the risks most pertinent to you and order them in terms of their impact on your comfort level. Some people couldn't care less if their portfolio's bottom line gyrates, as long as their income needs are comfortably met. Others can't sleep at night if they have any debt outstanding. While risk is an extremely individual topic, a successful and comfortable financial plan won't work without taking it into consideration.
Think in Probabilities
As you visualize what you want from your financial plan or portfolio, you should also spend some time thinking about the consequences of something going wrong. Because it carries the implication that our thought process or analysis may have been flawed at the outset , this line of thinking can be excruciating for most people,. Still, the market, economies, and politics are notoriously unpredictable. It pays to consider a variety of potential outcomes. While thinking in terms of probabilities (e.g., There's a 50 percent chance that X will happen and a 30 percent chance that Y will happen.) is unusual within our "all situations are clear cut or black and white" society, it can be extremely helpful in defining your asset management boundaries.
A key outcome of this kind of thinking is the apportionment of assets across a variety of categories in order to hedge the portfolio against specific risks. Examples include owning international securities as a potential offset to a declining dollar and/or in recognition of the increase in prominence of non-US markets or owning Treasury Inflation Protected Securities (TIPS) to hedge against inflation. Think broadly and openly about a range of potential outcomes. As Robert J. Shiller states in his book, Irrational Exuberance( 2nd Ed.), "If one tries too hard to be precise, one runs the risk of being so narrow as to be irrelevant."
Love Being Contrary
A hallmark of our ancient wiring is that we love to run with the pack. Indeed, neuroscientists have shown that physical brain receptors firing when we are excluded from groups are the same ones active in response to physical pain. It hurts to be excluded, at least as far as our brain (and stomach) is concerned.
When it comes to investments, running with the pack seldom ends well. More often, being an outright contrarian can be more profitable over the long haul. However, it is also an exceedingly difficult thing to tolerate, as it often requires blatantly challenging the conventional wisdom of the day. In early 2000, it meant going to cash rather than loading up on tech stocks. In today's market, it could mean unwinding hedge fund positions and looking for opportunities in real estate, homebuilders, and building supply stores.
Once you become accustomed to it, poking holes in what has become mainstream thinking actually becomes quite fun. If nothing else, it gives you plenty of interesting topics to share at your next cocktail party. For example, did you know that:
Consumer spending hasn't declined in nearly 70 years? The rate of change may vary from year to year, but as a whole we can be counted on to spend more this year than last.
According to data compiled by the U.S. Federal Reserves' Flow of Funds Study, U.S. individuals' joint net assets are nearly $70 trillion, while aggregate financial obligations are a bit over $10 trillion - giving us the most significantly positive net worth of any country on the planet?
Despite all the hand-wringing about the aging of our society, 20 percent of the population is under age 15, while only 12 percent of the U.S. population is over age 65 (according to the Population Reference Bureau's 2006 World Population Report)? This puts us more on a par with China (20 percent under age 15; eight percent over age 65) than Germany (14 and 19 percent, respectively) and Japan (14 and 20 percent, respectively).
S&P 500 earnings ended 2006 at a level more than 50 percent greater than their prior peak in 2000, yet as of this writing, that index is basically at the same level as it was at the last time it peaked in March of 2000? Roughly speaking, average valuations have been halved.
Since 1980, the U.S. economy has absorbed three serious recessions (1983, 1991, 2001) and several lesser ones?. It has also experienced double digit unemployment, double digit interest rates, two oil shocks' 9/11, three wars (give or take), the impeachment of a president, the Asian currency crisis, Russia's currency default, Mexico's currency default, the implosion of the "Asian Tigers," more than 10 years of an ailing Japan, an S&L Crisis, the default of a major U.S. utility (WPPS), the default of a major county (Orange County, CA), a crisis in commodities markets (Hunt Brothers), a hostage crisis, and a major nuclear event. It has also endured Enron, Tyco, Long-Term Capital Management and the other late 1990s notables; the near failure of a major Chicago bank; deregulation in airlines, trucking, phones; "mini bubbles" in LBO's, the debt of lesser-developed countries, HMO's, and the biotech (twice) and technology (at least twice) industries; and, finally, the demise of supercomputer companies, mainframe companies, and midrange companies. Just to name a few. Despite these challenges, the stock market (as measured by the Dow Jones Industrial Average) has increased more than 2000 percent since 1980 and is up 400 percent since 1990.
The bottom line: Of all living species, we are the only one with the ability to place a pause between the "stimulus and response" sequence. That pause, no matter how brief, allows us to make important choices as to how we shape our responses. With a little forethought and planning, our responses to investment stimuli can now be more reasoned - and more like the "homo economicus" that the economists have been telling us for years we already are.
Carol M. Clark, CFA, is a Partner and Investment Principal of Lowry Hill Private Wealth Management. Lowry Hill is an asset management firm that provides proprietary investment management and financial services to families, individuals and foundations with wealth greater than $10 million. We currently hold more than $6 billion in assets for nearly 300 families and more than 60 foundations from our offices in Minneapolis, Naples and Scottsdale.
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