This week we have been thinking a lot about behavioral finance. We all have behavioral biases, which are defined as irrational beliefs or behaviors that influence our decision-making process. As investors, its important that we understand what these behavioral biases tend to be and how to recognize them. Most importantly, we need to know what we can do as investors to avoid allowing them to drive our decision making. We are calling this post the “Highway to the Financial Danger Zone”.
Charlie wrote the article below originally as a report during his time in his MBA program. We also recorded our latest Pilot Money Guys podcast where we have a conversation about this topic. Please check those out and let us know what you think!
As always, if you have questions, comments, or would like to discuss this further please give us a call at 865-240-2292 or send us an email to Info@leadingedgeplanning.com.
Thank you for reading and listening!
Highway to the Financial Danger Zone
Charlie Mattingly 2012
Section I: Introduction
As behavioral finance gains traction in the financial planning industry we are starting to understand why the average investor struggles with emotional financial decision making in the heat of the battle known as market volatility. In this paper I will discuss real world conditions that cause us to continue to make poor investment decisions under ever increasing market volatility.
As a previous F-16 fighter pilot in the Air Force, I am accustomed to quick decision-making under stress. I will attempt to draw on previous training experiences in order to adapt some techniques that may be useful when preparing our clients to deal with extreme market volatility. Many times I have heard an experienced combat pilot say; “my training and instincts took over.” Why is it then that under actual life and death situations a trained fighter pilot can trust his or her emotional reactions when it seems the opposite holds true for investors in the stock market? Can we take fighter pilot training techniques and translate those to the investing world? I believe there are lessons to be learned here.
Before we move on to the investor training session, I will explore the brains evolutionary wiring system in order to understand why our primitive thinking processes cause us to make emotional decisions. Following this brief overview, I will discuss real world situations that demonstrate how changes in technology and complexity of financial decisions can contribute to harmful emotional decision making. Finally, I will provide tangible action items taken from military training strategies that if executed correctly can limit poor investor performance from faulty decision-making processes.
Mind Over Money?
The human brain is an amazing machine that is designed to protect us from life-threatening situations. The brain is wired to help us survive while simultaneously recognizing opportunities that increase our quality of life. Unfortunately, it is also wired so that during extreme stress our emotional brain dominates our decision-making process. In a study by Doug Lennick, CFP ® and Kathy Jordan, Ph.D. called “Money on Your Mind: The Brain’s Role in Financial Decision-Making.”1 They describe how the brain has three main sections that dictate our decision-making process; the Rational Center (Cortex), the Emotional Center (Limbic System), and the Habit Center (Basal Ganllia). The brain uses these three sections to work together to dictate how we make decisions and form habits. Because the brain has a basic fight or flight reflex, the emotional center of the brain tends to take over “operations” when we feel threatened.
Section II: Major Behavioral Influences on Financial Decision Making
Information At Our Fingertips, Literally
Rapidly changing technology and the information age sometimes causes faulty emotionally based decisions. Technology has provided us with the latest and greatest stock market information literally at our finger tips. There truly is an “app for that.” The technology available today allows all investors who own a smart phone to instantaneously know any stock price at the touch of a button. This means that as soon as any financial news of significance, or perhaps insignificance, is reported the information will be fully incorporated into market transactions almost instantaneously. This means we have to accept the speed at which the markets change and realize a 200-point swing in the markets doesn’t mean what it used to mean.
In a recent Money Magazine article2, Andrew Lo, M.I.T.’s Economist and Professor of Finance discussed the increased volatility and its effect on investors. The article shows that the number of sharp up-and-down days of the S&P stock index has been increasing. Since 2008 the S&P stock index has had 47 days with swings of more than 4%. There were only 26 days with swings of more than 4% from 1983 until 2007. Due to this increased market volatility some experts believe that buy and hold strategies will be extremely difficult if not impossible for the average investor to successfully execute. Andrew Lo says that “Buy-and-hold doesn’t work anymore. The volatility is too significant. Almost any asset can suddenly become much more risky…simply because of the nature of financial markets and how complex it’s gotten.”
The Tyranny of Choice
We’ve probably all heard the saying “paralysis by analysis.” This is a very real and serious condition that we should be concerned about with ourselves and our clients. Certainly, the federal government is very interested to learn how they can help educate current employees in order for them to make better decisions when saving for retirement. The future of retirement savings looks much different than the past thirty years. Benefit (DB) plans are quickly being replaced by Defined Contribution plans (DC) and therefore employees must take on the sole responsibility of making smart decisions about savings rates, asset allocation as well as lifetime withdrawal strategies.
Dan Ariely, Behavioral Economist and author of “Predictably Irrational” has conducted research on why seemingly simple choices to some are much more complex to others. Mr. Ariely addressed this “tyranny of choice” in a presentation titled “Are We In Control of Our Own Decisions” at a Technology, Entertainment, Design (TED) presentation3 and demonstrated how learning about the decision to become an organ donor can also help us understand how we can encourage workers to contribute more to their retirement plans at work. He demonstrated how individuals handle difficult decisions by referring to a study done by Eric Johnson and Daniel Goldstein4 called “Defaults and Donation Decisions.”
Johnson and Goldstein constructed the graph below which shows the percentage of populations in various European countries that chose to become organ donors.
They wanted to know why there was such a drastic difference in participation rates throughout countries that had relatively similar cultures. Researchers learned that the difference in choice wasn’t because certain countries cared about people more than others, but it was simply how the choice was presented. They discovered that the countries with the high participation rates decided to become organ donors because the decision to join was practically made for them. It turns out the major difference between high organ donor participation rates was due to the question on the form at the Department of Motor Vehicles (DMV) when citizens applied for their driver’s license. On the DMV form for the countries with high participation rates the questions was framed as follows; “Check the box below if you don’t want to participate in the organ donor program.” And you guessed it, for the countries with the low participation rates the question was asked in a slightly different way; “Check the box below if you want to participate in the organ donor program.” Dan Ariely surmises that low organ donor participation is not because people are too lazy to pick up their pencil and check the box, but because they are overwhelmed at the thought of deciding on such a question of immense consequences. Simply put, people would rather not choose at all when the decision is complex.
Section III: Combating Behavioral Enemies to Win the War Against Mr. Market
According to an annual study by Dalbar Inc., investor’s returns lagged market averages. For the twenty-year period leading up to 2011, asset allocation fund investors earned 2.56% compared to the S&P 500 return of 9.14%.5 This is a significant cost to our clients and could be the difference in a comfortable retirement or one filled with sleepless nights of worry.
So what are the techniques to combating the enemy we call emotional investing? I will discuss some techniques and strategies that will help advisors develop a training program for their clients so the market’s irrational behavior can be managed successfully and peacefully without leading to all out war on our client’s portfolios.
Client Training Strategies
In order to ensure a successful flying mission, significant time and effort was invested to develop specific, measurable, attainable, relevant, and time bound (SMART) goals. SMART goals are an absolute must with our clients. Furthermore everything we do for our clients should center on the accomplishment of their stated SMART goals.
Another important aspect of pilot training was learning to plan for contingencies or the unexpected. We were all very proficient at the actual flying of the airplane, in fact it was like second nature to most pilots, nonetheless it was always extremely important to have a plan for contingency operations and to effectively communicate the plan. Just as with financial planning, contingency planning is crucial to the success of our mission. Communicating with and educating our clients on the wide range of outcomes, good or bad, is the foundation of a trusting relationship. Furthermore, our clients need to hear from us that we don’t know exactly what’s going to happen in the markets. Obviously, we cannot foresee the future. The good news is that we can predict with confidence how we as investors will react emotionally under severe market stress. We can take this human behavioral information and develop a defensive strategy to protect us from our own behaviors and we should develop an offensive strategy to take advantage of the behavioral tendencies demonstrated by the stock markets.
Weapons Used to Combat Emotional Investing
In this final section I will discuss seven weapons we can use to defeat the enemy of emotional investing. Some are what I like to refer to as “embarrassingly simple, but amazingly effective” operations. As we have seen from the above case studies, we must simplify the seemingly complex for our clients. Just as with the world of training for aerial combat, things are often very complex and fluid. However, we as advisors must break down the complex scenarios and help our clients prioritize the actions needed to meet their investment goals in order to hopefully one day achieve true financial peace of mind.
- The Financial Plan. Helping our clients understand their current situation and the consequences of continuing their current course is absolutely essential. Developing and updating a financial plan is one of the most important items to help clients achieve their goals and peace of mind.
- Develop a Behavioral Investment Policy Statement. This policy statement can help set expectations and predict investor behavior. The statement can be used to set asset allocation parameters to operate within. The operating parameters give the client something to fall back on when they have emotional doubts due to typical stock market volatility.
- Develop a smart rebalancing strategy. Charles Rotblut, CFA said it best in his article titled “Portfolio Rebalancing: Diversification, Risk Control and Withdrawals.”6 “Rebalancing reduces a portfolio’s risk by maintaining the benefits of diversification…and providing an alternative to panic in the midst of a bear market.”
- Develop a rapport with your clients. There must be trust in order to make it through the gut wrenching volatility that investors will face going forward. The advisor-client relationship must be a mutually respecting and trusting relationship in order for the client to follow your advice in the heat of the battle.
- Educate clients about the different sources of financial information. It’s okay to watch 24-hour cable news shows, but understand that it is also entertainment. As a possible solution, ask clients (and yourself) to read about the financial news in a respectable newspaper or magazine instead of watching it on TV.
- Educate ourselves and our clients on the brains basic design and understand why we are vulnerable to very strong emotions that make it difficult to discern a wise and reasonable solution to one that was based purely on emotions. Just as with flying airplanes, there are very few decisions, probably zero, that have to be made right now.
- Help our clients to remain focused on events and actions that present the biggest risk to achieving their goals. Most of the time I find that clients, and people in general, are often afraid of the wrong things. We often fear things that have the least impact on our personal financial lives.
The statistics described in this paper4 clearly show that investors make emotional decisions repeatedly and will therefore lose much of the benefit of investing to psychological factors. I believe we must take into consideration an investor’s emotional state when developing portfolio strategies. Advisors have to meet the clients where they are emotionally in order to ensure they have the best chance to win the emotional battles ahead.
- “Money on Your Mind: The Brain’s Role in Financial Decision-Making.” By Doug Lennick, CFP®, with Kathy Jordan, Ph.D. Journal of Financial Planning April 2010
- Article from Money Magazine titled, “Wild Markets Are Here To Stay, Argues M.I.T.’s Andrew Lo. If He’s Right, Buy-And-Hold Investing Will Be Harder To Stick With.” Interview by Charles P. Wallace. March 2012
- Adapted from TED Talk by Dan Ariely December 2008. http://www.ted.com/talks/dan_ariely_asks_are_we_in_control_of_our_own_decisions.html
- “Defaults and Donation Decisions” Eric J. Johnson and Daniel G. Goldstein. January 7, 2009
- Dalbar Inc. Article titled, “Investors Can Manage Psyche to Capture Alpha. DALBAR Study of Investor Returns Offers Ways to Improve Investor’s Alpha.” April 1, 2011 http://www.dalbar.com/Portals/dalbar/cache/News/PressReleases/pressrelease040111.pdf
- American Association of Individual Investors (AAII) article written by Charles Rotblut, CFA. “Portfolio Rebalancing: Diversification, Risk Control and Withdrawals.”
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this Podcast will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any information or any corresponding discussions serves as the receipt of, or as a substitute for, personalized investment advice from Leading Edge Financial Planning personnel. The opinions expressed are those of Leading Edge Financial Planning as of 05/14/2021 and are subject to change at any time due to the changes in market or economic conditions.