I’m fascinated with the field of behavioral economics and have taught the subject for nearly 20 years. But theory must be applied to be useful. Here’s how I apply behavioral finance to help clients to think differently about their investing.
Behavioral finance recognizes that we are not rational, mathematical animals; we are emotional beings. We often deviate from traditional economics, which says we are unbiased by emotion and have consistent and coherent preferences when it comes to wealth and security. In fact, the weighting of those two preferences is predictably irrational. Wealth has a higher preference in a bull market while security rules the day in a bear market. Morningstar’s Mind The Gap Study shows investors’ poor market timing caused them to underperform by nearly 1.7% annually over the past decade. I review that Morningstar study with clients, making sure that they recognize this applies to them as well as investment advisors.
Prospect theory and recency bias
Clients must make a critical decision selecting an allocation between risky assets such as stocks and low-risk assets such as bonds and cash. More importantly, they must commit to stick with the allocation they select. In my experience, clients typically want to take on more risk than they need to, especially in a bull market. I look at the client’s need to take risk rather than relying on their willingness to take risk, which is poorly measured in a risk-profile questionnaire.
It’s one thing to ask a client how they would feel if their stock portfolio lost 50% or more; such a question elicits an idealized response. Though they might say they would buy more stocks to rebalance, few actually do. That’s because prospect theory demonstrates that we experience roughly twice as much pain from losing money as pleasure from making the same amount of money. Did they (or you) rebalance in the 33 days ending March 23, 2020 when stocks lost 35% as the pandemic hit?
I try to get clients to tap into that pain when they want to take what I feel is too much risk. I ask them to imagine the consequences of taking that risk if markets plunge. Those consequences could result in not being able to send the grandchildren to college, having to downsize their home, or having to move to a less-desirable neighborhood away from their friends who knew why they had to move. I encourage them to imagine how they might feel if they lost the dreams they worked so hard to achieve, and remind them that imagining the pain doesn’t come close to experiencing it.
Overconfidence and confirmation bias
These two biases are related. When a client comes to me wanting to make an investment they think is virtually a sure thing, I typically push back. Say a client is excited about making a private-market investment they were pitched. Or maybe they are heavy in a stock they don’t want to lighten up on. They may say something like, “Nothing is ever going to happen to Apple (APPL),” and cite articles they have read that bolsters their view.
I’ll respond by telling them that they are thinking with their “system-one” emotional brain, referring to Nobel Laurate Daniel Kahneman’s terminology. I urge them to use their “system-two” logical brain, which takes more effort to activate. Kahneman’s research on these two systems of thinking is described in his book, Thinking Fast and Slow.
If the client can’t identify at least three things that would cause any investment to have a very bad outcome, I point out their bias and come up with at least three of my own. Will Apple (or any stock) always be one of the most valuable companies on the planet? Well, General Motors and Eastman Kodak once were, and their bankruptcies wiped out the common shareholder. The five most valuable U.S. companies (market caps over $1 trillion) didn’t even exist 40 years ago, so it’s likely the most valuable companies in a decade or two will look very different than today, especially with technology changing at a much faster pace.
Data mining and hindsight bias
We humans have a knack for finding patterns out of randomness, especially when it comes to investing. For instance, from 1991 to 2005, it was thought that small-cap-value stocks were a free lunch to greater returns without additional risk. Bill Miller’s Value Trust Mutual fund had stellar performance for 15 years. But with thousands of mutual funds, some were going to have outstanding long-run performance likely by sheer luck. Assets poured into his fund, as investors believed Miller was a star amid a sea of randomness, only to be disappointed when his fund crashed. This is different from situations like Cathie Woods’ ARK Innovation fund, which had a “hot hands” run that lasted just a few years. I’m referring to patterns that persisted for well over a decade.
Today, I see people underweighting international stocks due to underperformance and explaining it’s likely to continue to do so because of problems overseas, as if it hasn’t already been priced into the market. I also see the overweighting of large-cap growth because of its outstanding performance over the past 15 years. Those smart-beta patterns are likely to work as well as the Dogs of the Dow, and I don’t think large-cap growth should be overweighted today.
Like heat-seeking missiles, we are programmed to lock in what has performed well in the past and explain why we think we are acting logically with sophisticated explanations. In my push back, I try to get the client to recognize that they are data mining and logically explain what is really randomness.
Anchoring
Some clients are okay selling their winners but want to hold on to their losses. In fact, in a class I taught to CPAs for many years, I asked the following question: You’ve been gifted $10,000 and you buy two stocks with $5,000 each. Over the next month, stock A goes up to $7,500 while stock B declines to $2,500. If you had to sell one stock, which do you sell? The vast majority picked stock A because they lock in their brilliance while they are anchored to the higher purchase price of stock B and don’t want to lock in the loss.
Because the money was gifted, this had to be in a taxable account, but even CPAs, trained for tax efficiency, chose to pay a short-term gain rather than harvest the loss. This is a flawed economics-based decision. This assumes they had no insider information to believe that stock B was undervalued. I joke with clients that “I’m sorry for your loss,” but advise them to make the best of it by harvesting those losses.
Framing
People frequently frame issues wrongly. Here are just a few examples of how I help clients reframe a decision:
- “Cash is a riskless asset.” Perhaps this is less true today (with an inverted yield curve) but for most of the past two decades, cash was paying far less than inflation (after taxes) and was the surest way to lose spending power. I advise the client to “get real,” as in looking at returns after inflation and taxes.
- “It’s not worth my time to move cash to earn more.” I ask the client if I can I buy an hour of their time for $3,000 because that’s the extra money they could safely make each year with a higher yielding account and treat themselves to something extravagant with some of that extra money.
- “I want to pay the least amount of taxes.” The better goal is to make more money after taxes.
- “This product gives me a paycheck for life.” A couple of decades of compounded inflation could cause that paycheck to be worth very little.
My own theory – Relative performance prospect theory
There is one theory I haven’t seen written about that I also use to get clients in low-cost total cap-weighted stock funds. I’ll call it the “relative performance prospect theory.” Though we know that losing money causes more pain than making the same amount, I propose relative performance adjusts the pain. Losing money will hurt far more if your friends didn’t also lose at least as much. Vanguard founder John C. Bogle once told me that investing has always been about outpacing your friends, and owning the whole market at the lowest cost virtually assures this for each asset class.
Conclusion
It’s impossible for us to eliminate emotions in our investing. But it’s critical that we help clients to be aware of and manage those emotions to at least lower the impact of our behavioral mistakes.
These are just some of the ways I apply behavioral finance in working with clients. I sometimes throw in a little humor in noting they can call me “Argumentative Al.”
Applying traditional economic financial theory with lessons from behavioral finance will lead to a higher probability of better financial outcomes.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multi-billion-dollar companies and has consulted with many others while at McKinsey & Company.
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I’m fascinated with the field of behavioral economics and have taught the subject for nearly 20 years. But theory must be applied to be useful. Here’s how I apply behavioral finance to help clients to think differently about their investing.
