The Sky is Falling – Again
As I write this column, the world may be coming to an end as the powers that be can’t seem to come to terms with what needs to be done in managing their powers. Or, we will kick the political/economic can down the road? Do you feel like we move from one crisis to the next? How does this play out in your investment strategies? How do you manage the emotional roller-coaster ride that the markets seem to have us buckled into and not letting us off?
Daniel Kahneman, PhD, a psychologist won the Nobel prize in economics in 2002 for his groundbreaking work in the areas of judgment and decision-making as applied to economic theory. On October 14th of this year, Robert Shiller, an economist, shared the prize with two others. He is another pioneer in the field of behavioral economics. It seems that our emotions, biases and preferences can collectively influence the financial markets. As we understand our own behavior and our tendencies towards acting on them, we can learn discernment as to our decisions and hopefully keep from making some expensive mistakes.
Investors tend to imitate others – called “herding”. We believe that we have all the information that justifies our actions. This will create a feeling of safety in numbers and will lead many into jumping into a “hot investment”. Remember when real-estate was king in the valley and everyone was building a spec-home or studying for their real-estate license?
Investors tend to overestimate our knowledge and predictive abilities. This can result in excessive, irrational trading. Believing they can’t be wrong, it is difficult to adjust viewpoints in the face of contradictory evidence.
Investors will pay more attention to short-term ups and downs of the stock market and forget its long-term direction has been up. We do need to pay attention to what type of economic environment we are in, as well as your time frame for investing and allocate appropriately, but you don’t want to react to underperformance in the short-term.
Investors can have “hindsight bias”. We tend to attribute our successes to our intelligence and poor decisions to bad luck. This can lead to the buy high, and sell low cycle.
Investors can experience “anchoring”. We have strongly-held opinions and are reluctant to revise our views in the face of new or contradictory information.
These are a few of many quirks in human psychology that combined with traditional economic theory can make for very challenging investment environments. What do we do with the fact that our brains don’t work well on money?
Setting financial goals can help us to harness these behaviors and keep our minds focused on what really matters in life. You will be more pro-active and less reactive as you manage what is within your control. As you commit to a holistic approach to a healthy financial life and wealth management you will be more rational in your decision making. You won’t chase returns as the parameters of success, but embrace good investment behaviors as the function for reaching your objectives. Know that your targets will shift over time, as does everything in life. So the key to a financial plan is the planning process itself. It is a continuum – constant course corrections to keep you on track with the trajectory you want. This process will involve communication, between family members and your trusted team of advisors. As you have good, meaningful conversations around money, your level of quality decisions will also go up. Recognizing, understanding and managing our beliefs, biases, and emotions around money are indispensable for creating sanity both in our homes and in the markets.