Take a Walk on the Mild Side?

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

A friend recently sent me an interesting article entitled How Happiness Comes With Age - Becoming Okay With Being Boring.  I’m guessing I liked the title so much because I am a CPA and have mastered the art of being boring.  If you ever need someone to liven up a party, just give me a call and I will give you the phone number for my friend Ron - he is really fun.

One particular part of this article jumped out at me as it relates to investing.  The writer was discussing our gradual shift as we age from adventure seekers to safety seekers:

“Social psychologists describe this change as a consequence of a gradual shifting from promotion motivation -- seeing our goals in terms of what we can gain, or how we can end up better off, to prevention motivation -- seeing our goals in terms of avoiding loss and keeping things running smoothly. Everyone, of course, has both motivations. But the relative amounts of each differ from person to person, and can shift with experience as we age.”

Gain Seeking vs. Loss Avoiding
What I love about this visual is that it points out something that is critically important to acknowledge in managing your financial life:  we all have this internal tug of war going on between our adventure seeking, gain seeking side and our safety seeking, loss avoiding sides.  I guess you could say we all have a wild side and a mild side.

Who Wins?
Most often, the deciding factor in who wins this epic battle between our wild side and our mild side is the stock market’s recent performance. When the market is going up, our adventurous, gain seeking, wild side takes the wheel. All we want to know is - how can we make more?! When the market is going down, our cautious, loss avoiding, mild side grabs the wheel. All we want to know is - how can we stop the bleeding?!

The Key
Having someone grab the wheel can have devastating consequences whether you are driving a car or investing your portfolio. That is why it is critically important to your long-term financial health that you invest in a portfolio that satisfies both sides of you - your gain seeking, wild side and your loss-avoiding, mild side. In other words, the key is to design a portfolio that you (and the other you) will be happy with if the market goes up or down. So, the next time you are tempted to make a dramatic change in your portfolio, ask yourself, “Is my wild side or my mild side trying to take over here and make me do something I will regret?”

I have to go now; I am going to try to offset my boringness with a little wild living. I’m thinking seriously about leaving the cap off my pen when I leave for the weekend.  On second thought, maybe I will just leave the cap slightly loose.

How To Tell Your Spouse You Lost $262 Million

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

Easy Come, Easy Go
In his book, Why Smart People Make Big Money Mistakes, Gary Belsky relates a fable that goes something like this:

By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance.  That night in bed, the groom noticed a glowing object on the dresser.  Upon closer inspection, he realized it was a $5 chip they had saved as a souvenir.  Strangely, the number 17 was flashing on the chip’s face.  Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $5 chip on the square marked 17.  Sure enough, the ball hit 17 and the 35-1 bet paid $175.  He let his winnings ride, and over and over the little ball landed on 17, until he had amassed more than $262 million.  Feeling invincible, he once again bet it all on 17.  As the wheel spun and came to a stop, he watched in shock as the ball fell on 18 and he lost everything.  Broke and dejected, the groom returned to his hotel room.  “Where were you?” asked his bride as he entered.  “Playing roulette,” he answered.  “How did you do?” she asked.  To which he replied, “Not bad.  I lost five dollars.”

How’s that for creative framing?  While you may never have to present or “frame” the loss of $262 million to your spouse, we all face important financial decisions that need to be framed properly.  In the most basic terms, framing can be thought of as the way something is presented to you. 

Better Frames, Better Decisions
This is incredibly important because the way something is presented to you will change your view or perspective of that thing.   And when your view of that thing is changed, then what you believe about it can change and that belief leads to action -- because we ultimately act on what we truly believe.

The progression is subconscious, but it normally goes something like this:  Framing changes your perspective, your perspective changes your belief and your belief changes your behavior.  Because of this, framing can encourage helpful behaviors or it can encourage harmful behaviors.

Knowing that good financial decisions begin with good framing and perspective, here is what I believe is one of the most important frames that will help you make better financial decisions.

Cycles Are Normal
▪ Properly framed, you should view market cycles as a healthy part of normal economic and market activity. Improperly framed, you may view economic and market cycles as something scary and unusual.  This belief (born out of improper framing) will generally lead you to fear market cycles and to try to avoid them. This behavior will almost certainly hurt your returns over the long term.

▪ Even though market cycles are normal, it is important not to confuse “normal and expected” with “predictable and the same.”  Because of this, it is certainly a fool’s errand to try to time a cycle’s next peak or valley.  As Peter Lynch famously said, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."

▪ However, you can systematically take advantage of market cycles, not by predicting them, but by rebalancing your portfolio when market swings have significantly altered the value of various assets in your portfolio.  In essence, rebalancing helps you “buy low” and “sell high” in a disciplined way.

Pizza Anyone?
Framing is so critical because it can change your perspective, and ultimately your behavior (for better or for worse), on your important financial decisions.  Because as I said earlier, framing changes your perspective, your perspective changes your belief and your belief changes your behavior.  For this reason, good decisions start with good framing.  So the next time you have a big decision to make, stop and ask yourself (and a few friends), “Do I have this decision framed properly?”

On a lighter note (and as further evidence that framing impacts our behavior), framing can even make you feel better about the not so helpful behavior of eating an entire pizza in one sitting.  It is rumored that Yogi Berra was once asked into how many slices he wanted his pizza cut.  To which he answered, “You better make it four, I’m not hungry enough to eat eight.”

Warning: Being Helpful Might Hurt Your Marriage

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing, Technology

A recent study by Norwegian researchers Thomas Hansen and Britt Slagsvold found that equally sharing housework between spouses might be bad for your marriage. After analyzing data of thousands of Norwegian couples, Hansen and Slagsvold found the divorce rate was higher for those doing equal amounts of housework than in couples where the women did more of the work. My first thought after reading this was that the International Association of Married Men must have funded the study.  Okay, there is no International Association of Married Men (at least not that I am aware of), but the study and the findings are real. 

Now before every married man reading this blog picks up the phone to call his wife and tell her this amazing news (and before every married woman reading this blog sends me hate mail), please read on.

Reading the findings of this study made me think of an important financial truth that you need to be mindful of in managing your family’s finances.  Namely, that correlation is not the same as causation. Let me translate that from geek speak. I will never forget my first introduction to this truth when my statistics professor in business school told us that there was an almost perfect correlation between liquor sales and pastors’ salaries. As young impressionable students, we were all shocked, to say the least. That is, until he explained that there is a difference between correlation and causation.

In the most basic terms, correlation says that two things move together.  For example, pastors’ salaries increased at the same time that liquor sales increased. So, they were in fact correlated. Now for the more important question - did the increase in pastors’ salaries cause the increase in liquor sales? Hopefully not! You see, therein lies the danger of assuming that the one thing (increased pastors’ salaries) caused the other thing (increased liquor sales). There was correlation, but most likely not causation.

Why is this important when it comes to your financial life?  Because somebody may provide evidence that two things are correlated and then imply that one thing caused the other. Causing you to make faulty decisions.

Take the so-called “Super Bowl Indicator” for example. The indicator says that the stock market’s performance can be predicted based on the outcome of the Super Bowl that year. You see, there is in fact a high correlation between which NFL conference wins the Super Bowl and the performance of the stock market that year. The indicator says that if an NFC team wins the Super Bowl, the stock market will have a good year and if an AFC team wins the Super Bowl, the stock market will have a bad year.  It has actually been right in 33 out of the last 41 years – a success rate of over 80%.  What do the two things actually have to do with each other? Nothing! There is correlation but obviously no causation.

Assuming there is always causation where there is correlation can be hazardous to your financial life…and in the case of the Norwegian marriage study – hazardous to your marriage!

One Sale People Avoid

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

People who know me well will tell you that I tend to get in a rut when it comes to food (I prefer to think of myself as consistent).  If I’m not going out to lunch on a particular day, one of my ‘rut’ foods is a pack of tuna with some lemon.  It’s easy and inexpensive - a beautiful combination to my way of thinking! 

What is also beautiful to a numbers guy like me is walking into the grocery store and seeing that one of my ‘rut’ foods is on sale.  So you can imagine my excitement the other day when I went to our local Giant and saw that tuna fish was on sale for 4 for $5 (I’m a CPA, so my definition of exciting is probably different than yours).  For those of you not familiar with tuna fish economics, that is 30% off Giant’s regular price of $1.79 per pack.

Knowing that I am definitely going to be buying tuna at some point in the future, what would you think if I told you that instead of buying a box load of tuna that day, I decided I would wait until the price went back up to $1.79 per pack?  That would be foolish, of course!  Sadly, based on my experience of over 20 years in the financial services industry and every credible study I have seen of human behavior, that is exactly the approach most individual investors take when it comes to investing in the stock market.  If history is any guide, it seems that one sale people hate is a stock market ‘sale’.

For example, out of fear, people generally avoid buying the S&P 500 index when its price has declined but are eager to buy it once its price has gone back up.  That’s a losing formula whether you are buying tuna fish or stocks!  Just ask Warren Buffett.  He has amassed a $40 billion fortune capitalizing on this madness.  He is quoted as saying - “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”  Translation: Buffett buys as much ‘tuna’ as he can when it goes on sale and nobody else is interested in buying.  He loves a stock market 'sale' and perhaps you should too.

Death By Anecdote

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

Suppose you have a perfectly healthy 100-year-old neighbor who never exercises and smokes two packs of cigarettes a day. Would you quit exercising and start smoking two packs a day in hopes of living a healthy life into your 90s?  Would you begin living your life based on their story?  Of course not!  This could, quite literally, lead to death by anecdote.  You would be making a serious, life altering decision based on a single data point – your neighbor.  As silly as this example seems, you may unknowingly be making investment decisions based on the financial equivalent of your 100-year-old chain-smoking neighbor.

It is incredibly important to avoid making your investment decisions based on the stories and limited data presented by financial prognosticators, financial “experts”, people selling books and seminars, etc.  The stories and facts presented are generally hand selected to lead you to draw a certain conclusion.  If enough stories and facts are pieced together, you can get the false impression that you are hearing all the data.  Always remember that the plural of anecdote is not fact.  Left unchecked, making investment decisions based on stories, anecdotes and limited data can cause you to make rash decisions and abandon a disciplined and well thought out financial strategy.

Burger, Fries and a Plane Crash

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

Well-known risk consultant Peter Sandman wisely observed that, “The risks that scare people and the risks that kill people are generally entirely different.” Why is this? His conclusion is that it has to do with control and familiarity. It seems that we are much less afraid of things that are familiar and that we feel are in our control (even if they are, in fact, much more dangerous).

The truth of Sandman’s observation hit home for me one day as I was enjoying a juicy burger and freshly cut French fries at one of my favorite burger spots. A story about a plane disaster flashed across the television. My blood pressure rose a bit as I followed the developing story, but soon I turned my attention back to my meal. As scary as a plane crash is, as I drove home on a typically crowded Northern Virginia road, I realized that the risk of dying in a plane crash was far more remote than the risk of dying while driving home – or of the burger and fries eventually doing me in.

However, the burger is certainly not very scary (and it is tasty), and for most, driving is certainly far less scary than flying.  This makes perfect sense when you consider Sandman’s criteria of control and familiarity. When we drive, we are behind the wheel and in control, and we drive pretty much everyday, so it is familiar. Flying, on the other hand, is eminently less familiar. Tony Kornheiser probably spoke for many people when he wrote in a column: “I’m somewhat anxious about flying. I recently made a list of things that scare me most about flying, and I narrowed it down to three: takeoff, landing, and the part where we’re in the air. Other than that, I’m fine.”

After more than 20 years in the financial services industry, I have definitely observed that the things that scare people and the things that kill people (financially) are entirely different. When it comes to investing, the thing that scares people the most are the markets’ short-term ups and downs like we are currently experiencing. However scary these market fluctuations may be, having a well-constructed portfolio that is part of a well-designed financial plan can prevent those fluctuations from being deadly to someone’s financial life. What is deadly is people’s responses to these market fluctuations.

Without a good plan in place, you will be tempted to counter your fear by trying to regain the “feeling” of control by doing something. The most common “something” that I see people doing is to start selling the things that are scaring them – whatever investments are currently dropping in value.

The outcome of following this path is generally very predictable and deadly – it devastates long-term performance. The reason is simple – more often than not, you inadvertently but relentlessly jump into an endless cycle of selling low and buying high. You are selling what has recently dropped in price and buying it back later – after it has gone back up in value…and feels safe!

With a good financial plan in place, while the markets’ ups and downs may continue to scare you, you can have the confidence to stay the course and avoid potentially killing your financial future.

Lessons From a $2 Billion Loss

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

I would like to put forth my first nomination for the understatement of the year award. For this prestigious award I would like to nominate Jamie Dimon, the CEO of JP Morgan. In response to a trading bet that lost $2 Billion (yes, that is billion with a ‘B’), Mr. Dimon said that the trading bet that the firm made was “poorly reviewed, poorly executed and poorly monitored”. To my way of thinking, “poor” seems to leave the door open on the performance scale to something worse, like say, “terrible”. If a “poorly reviewed, executed and monitored” trade produced a $2 billion loss, I would hate to see what the results of a “terribly reviewed, executed and monitored” trade would be.  I for one would not be sticking around to find out.

As an investor, what can you learn from JP Morgan’s $2 billion loss?  Here are two big things -

Don't Buy Things That You Don't Understand 
In the case of JP Morgan, they said that the strategy they had been using to hedge risks "has proven to be riskier, more volatile and less effective as an economic hedge than the firm previously believed."  That's a fancy way of saying they didn’t understand what they were buying. They had a created a monster and the monster turned around and bit their head off. Let this serve as a cautionary tale - don’t buy things that you don’t understand.

Don’t Judge a Decision Based on the Outcome
If I tell you that I am about to drive 100 miles per hour on my drive from DC to New York City would you have to wait and see the outcome of that decision before you could tell me whether that was a good decision or a bad decision? Of course not. Whether I make it in record time or plow into the back of an 18-wheeler on the NJ Turnpike, it is a bad decision. The outcome does not determine the quality of the decision. 

In the same way, although it is tempting and convenient, don’t judge a financial decision as good or bad based on the outcome or the results. The quality of a decision should be judged ahead of time based on the merits and the quality of the decision itself. I will assure you that the JP Morgan trade would have been touted as brilliance if the bet had gone the other way and JP Morgan had made $2 billion. Although the facts would have remained the same - to quote Jamie Dimon, they still would have made a trade and a bet that was “poorly reviewed, poorly executed and poorly monitored”. Just like a decision to drive 100 MPH from DC to NYC is a bad decision even if you make it to NYC in record time, making a financial decision that is “poorly reviewed, poorly executed and poorly monitored” is bad even if you end up making money.

Are You In a Place for Some Feedback?

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

Previously, we discussed overconfidence and its dangers when it comes to investing and making financial decisions. In this post, we want to talk about some fairly simple things you can do to combat overconfidence.

One of the best therapies for overconfidence is feedback. In a nutshell, feedback allows you to compare what you thought would happen with what actually happened. In some cases, life can give us feedback immediately. For example, you touch a hot stove, you get burned—quick feedback.

The world of sports can provide immediate feedback as well. In basketball, when you take a shot, you expect to make the shot. The good news (and the bad news, perhaps) is that you get feedback right away: The shot goes in or it doesn’t. This feedback is an important part of the calibration process. The goal of calibration, over time, is to shrink the perception gap - the gap between your perception of reality and actual reality. Take enough shots in basketball, and eventually you will probably become well calibrated regarding your basketball skills (or in deep and obvious denial).  The gap between your perception of your basketball skills, and your actual basketball skills, should shrink over time.

Based on my observations, the root of overconfidence in the financial realm is a result of people being poorly calibrated. In other words, there is a big gap between people’s perception of their stock picking and market timing skills and their actual stock picking and market timing skills.  I think this stems from a lack of feedback due to people generally being really bad financial record keepers with incredibly selective memories. We have a mind like a bear trap when it comes to remembering our winners, but have acute amnesia when it comes to our losers.

Fortunately, there’s hope if you use my incredibly inexpensive feedback mechanism--a pen and pad of paper. That’s all you need. Then, simply write down your predictions and feelings regarding the markets or a particular stock at any given time. Most importantly, write down your predictions when you feel most strongly about something, as that is probably when you are most susceptible to a case of overconfidence. Then go back and regularly compare what you wrote down with what actually happened. Over time, I am fairly confident (okay, hold the snarky overconfidence comments!) that this will be a humbling and eye-opening experience. Over time, this feedback will help you to become better calibrated when it comes to your financial decisions.

Unfortunately, there is no cure for overconfidence or any of these natural tendencies. They are deeply ingrained in us and are part of what it means to be human. The best you can hope for is to put on some constraints to manage yourself and keep overconfidence at bay. As a substitute for the bad investment behaviors often caused by overconfidence, try adhering to less glamorous, but far more reliable, time-tested principles of investing, such as the boring but effective diversification, dollar-cost averaging and rebalancing.

The next time that a friend or neighbor confidently tells you where the market is headed or that Facebook is a no-brainer investment, you can politely nod, knowing that you are probably witnessing a real-life occurrence of overconfidence. Perhaps, as a friend, you could suggest that he or she buy a pen and a pad of paper.

The Wrong Kind of Contrarian

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

Well, this chart pretty much says it all about human beings not being naturally inclined to make good financial decisions.  For those of you that don't like charts, I will summarize - individual investors are prone to sell when they should be buying and prone to buy when they should be selling.  Over the last several years, as stocks have been rising, individual investors have been pulling funds out of stocks (yes, those outflow numbers are in billions!):

Click here for the full article in the Wall Street Journal.

I’m An Excellent Driver

By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU

Filed under Behavioral Finance, Investing

We often misjudge ourselves and overestimate our abilities. In a word, we are overconfident. If you are confident that you are not overconfident, then I would suggest that you might want to keep reading!

One of my favorite examples of overconfidence was a survey where a group of people was asked to rate their driving abilities. Approximately 90% of the respondents rated themselves as above average drivers! It doesn’t take a Ph.D. in statistics to know that this is statistically impossible (unless, of course, you live in Lake Wobegon). In Why We Make Mistakes, author Joseph Hallinan said it well: “Almost all of us walk around with the private conceit that we are better than average.”

My apologies to my male readers, but Hallinan went on to point out that studies show that men, on average, tend to be more overconfident than women. He referenced one study where people had to estimate their IQs: Men almost always overestimated their IQs and women almost always underestimated their IQs. This overconfidence is particularly prevalent in male-dominated fields such as the military and finance. Unfortunately those are areas that have incredibly serious consequences to overconfidence.

In my experience, a propensity toward overconfidence starts at a young age. As a Little League coach, I witnessed the overconfidence of a child predicting a home run as he walked up to the plate. At those times, I chuckled to myself, thinking a more realistic goal would be to simply hit the ball. But at times as adults, that “I’m going to hit a home run” syndrome causes us to overestimate our capabilities.

For financial decisions, overconfidence can trick us into believing we can hit a financial “home run” by identifying the next “sure thing.” For example, the buzz around Facebook could lead you to conclude that Facebook is a sure thing. Here are some telltale signs that you may be falling victim to financial overconfidence:

• Practicing market timing
• Concentrating assets in one or a very limited number of holdings
• Abandoning investment disciplines, such as diversification
• Never establishing, or deviating from, a sound investment strategy

When it comes to your personal finances, overconfidence can cost you dearly. Fortunately there are things that you can do to help counter your natural tendency to be overconfident and help you be a better investor and make better financial decisions. We will cover a few of these items in future posts.

Behavioral Finance