For what I want to do I do not do, but what I hate I do.
In my own Christian walk over the decades, one of the biggest challenges in my life has not necessarily been the issue of knowing the right thing to do, but rather actually doing that right thing which I already know! The Bible often references this disconnect between “knowing” and “doing.” In Matthew 26:41, we read the oft quoted “The spirit is willing, but the flesh is weak.” Similarly, Romans 7:15 insightfully notes “For what I want to do I do not do, but what I hate I do.”
This propensity to know the right thing to do, but to do otherwise manifests itself when investing as well. Our piece, Matters of the Heart, discusses the pitfalls of emotion-based investing. The relatively new field of Behavioral Finance is predicated on the thesis that investors make sub-optimal decisions due to a number of common psychological tendencies. These behavioral shortcomings cause investors to make imprudent investment decisions, oftentimes enthusiastically buying at high market levels and despondently selling at low market levels. Investors find themselves doing the exact opposite of what they know they should do…buy low and sell high. In other words, Behavioral Finance teaches us that even when investors know the right thing to do, they oftentimes do otherwise. Sounds like something we might read in the Bible, yes?!
Behavioral economist, Dr. Richard Thaler, winner of the Nobel Prize, refers to people who always make rational economic decisions as mythical “Econs,” who do not really exist in real life. Real, flesh and blood humans, Thaler contends, are subject to emotions, biases, heuristics, etc. which cause us to make decision-making errors that Econs would never make. Benjamin Graham, the legendary economist, investor, and professor (Warren Buffett was his student!), summed up the challenge well, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
There are several key Behavioral Finance mistakes that investors make. With a) Loss Aversion, investors mistakenly overweight the pain of potential losses while underweighting the benefit of potential gains; b) Anchoring causes investors to cling to prior reference points, vainly longing for things to return to “normal” or to get back to “even,” while failing to adapt to changed market conditions; and c) Recency Bias, investors extrapolate the latest market direction, up or down, far into the future. While being finite does not mean being sinful, the limitations that behavioral finance identifies in all of us provides an opportunity for greed and fear to take advantage of our finite nature.
So, given that the Bible as well as the field of Behavioral Finance teaches us that, as humans, we are predisposed to do those things that we know that we should not do and to not do those things that we know that we should do, what measures can investors take to mitigate these behavioral errors, especially during these anxiety-provoking Pandemic times?
- Make a Written Plan – In our piece, What’s The Purpose?, we discussed the importance of an investor first determining the specific financial goal(s) in order to achieve a successful investment outcome. To increase the probability of achieving those financial goals, experts agree that having a specific, written plan to accomplish that goal(s) is critical. Then, referring back to that written document on a regular basis (e.g. quarterly), affords investors a helpful, consistent reminder to counter fluctuating emotions in the midst of market moves.
- Hire an Advisor – Certainly, hiring a financial advisor provides very important knowledge and expertise for investors. However, even beyond that, a financial advisor can serve as an important “personal trainer” that helps investors overcome bad habits and poor decisions. Also, an advisor can be an “accountability partner” to whom one must explain a significant financial decision before taking action. This can help keep investors from being swept up in market bubbles or panics.
- Automate – Investors should seek to systemize their investment activities as much as possible so that emotions do not affect their investment decisions. Automatic contributions to a retirement plan from one’s regular paycheck is a good example of a way to overcome behavioral finance weaknesses. Dollar Cost Averaging (DCA) is a systematic way to take emotions out of play by deploying a given dollar amount into investments on a predetermined schedule. Dollar Cost Withdrawals (DCW) does similarly for taking money out of investments. Likewise, a set rebalancing plan (calendar or percentage based) is an unemotional way to trim back investments at relative highs and redeploy the proceeds into other investments near relative lows.
- Employ Values-Based Investing – When investors see their investments as not only a means to achieving financial goals, but also goals of a “higher calling” (e.g. Biblically Responsible Investing), they are less likely to get caught up in bouts of market euphoria or despondency. When investors view their investments as “dual-purpose,” they are more likely to maintain a longer term perspective in the midst of gyrating emotions.
- “Bucket” Investments – The Behavioral Finance concept of “mental accounting” describes the financial mistakes people make by categorizing money into differing accounts and not considering wealth implications holistically when making decisions. This tendency, however, can also be used advantageously in the investor’s continuing fight against fear and greed. By separating investments into two categories of 1) “preserve wealth” (lower risk, lower return investments) and 2) “grow wealth” (higher risk, higher return investments), investors are more likely to maintain a long term investment strategy, even in the face of feelings brought on by market volatility. In Bear Market To Do List, we discussed the importance of having 6 to 24 months of living expenses held in safe, low-yielding cash, savings, or money market accounts in order to weather short-term market turbulence.
- Utilize “Insurance” – Employing a strategy of rolling, deep out-of-the-money put options on broad equity indices can function like an insurance policy to help shield investors against catastrophic investment losses. This empowers investors to pursue a more prudent long-term investment strategy. Like insurance, however, this peace of mind does come with a deductible (the amount the put option is “out-of-the-money”) as well as the on-going cost of the premiums that must be paid to maintain the protection.
- Reframe Time Periods – The typical investor’s financial goals are measured not in days, weeks, or months, but rather years, decades, and generations. Therefore, while it is nearly impossible in our present-day, always-connected world to drown out the noise of financial market news, investors are well-served to commit to reviewing their investment portfolio’s performance only on a scheduled basis (e.g. quarterly). Further, in order to mitigate impulsive decisions, past investment performance should be viewed as long term only (five years or more, if available) and on a cumulative basis rather than annualized.