Discipline is essential if you seek financial success.
With our children, we use discipline to help them improve their behavior. Applying discipline to financial decision making also provides benefits.
While most people do not consider how their emotions and behaviors affect their financial success, studies have shown that along with high expenses and tax inefficient investments, human behaviors are the most detrimental forces impacting people’s financial well being.
The chart below illustrates the sad truth that the average investor does not do a good job of capturing the market returns. Worse still, the average investor lost money in real terms by under-performing the rate of inflation over the past twenty years. Market timing failures and other emotional reactions have the greatest impact on the poor investment results.
An entire branch of research, known as behavioral finance, has been initiated in the last several decades to focus on how emotion and behavior influence financial results. While the researchers continue their debates, the evidence is plentiful that our emotions often lead us to behave in ways that damage our financial well being.
Professor Dan Ariely at Duke University has studied how investors consistently make the wrong decisions. One of his findings is that the “default option,” which essentially is maintaining the status quo, is very powerful. As problems become more complex, the likelihood of the default option being chosen increases. Given that many financial decisions are complex, it increases the chances that individuals will miss opportunities by failing to act.
Another challenge we face in making good financial decisions comes from the role that emotions play in keeping us from following our good intentions. When time frames are compressed, we are more likely to base decisions on emotions rather than sound reasoning. To combat these emotional forces, it can be helpful to have written goals and a written investment policy statement (IPS). Assuming the goals and the IPS are established in a thoughtful manner at a time with low stress, they can guide our actions when the time frame for decision making is short and our emotions are high.
The following pitfalls arise from investor behavior dominating rational thinking:
ANCHORING: People attach significance to arbitrary start dates and values. For example, let’s assume you purchased a stock on June 1, 2008 for $100 per share. Today the stock price is $80. You continue to hold the stock because you
ANCHORING (continued): believe the “real” value of the stock is greater than or at least equal to the $100 you paid. In reality, the stock’s value is determined by a number of factors, none of which happen to be what you paid for it. Yet many people will refuse to sell a stock at a loss. To combat this anchoring bias, we need to reframe the issue. If you were starting from scratch, would you want to own the stock at its current value? Another approach is to consider whether your desire to hold the stock would be the same if you purchased the stock for $40. Other than for tax planning purposes, what you paid for an investment should have little relevance when deciding whether it is appropriate to continue to hold the investment.
SPOTTING TRENDS THAT AREN’T THERE: With the incredible amount of information available today, people find trends in data and infer causality from them. A commonly cited example is the predictive ability of the winning conference in the Super Bowl to determine the direction of the stock market. While the Super Bowl Indicator had a 90% rate of accuracy from 1967 through 1997, its predictive ability then failed the following four years. Obviously, the winner of a football game has no impact on the direction of the stock market. However, past high correlations led some investors to approach the markets aggressively or conservatively based on the outcome of the big game. We must remember that correlation does not equal causation.
OVERCONFIDENCE: From time to time, we are all guilty of thinking we are smarter or better than we really are. Ola Svenson’s famous study in 1981 found that 93% of Americans rated their driving skills above average and 88% rated themselves safer drivers than the average. The problem exists in the financial world as well. Having made a couple of successful investment decisions, many investors will attribute skill to their outcomes. This overconfidence in one’s skills can lead to short cuts and an over-reliance on intuition. The results can be disastrous as people place increasing weight on their “skill” only to have their luck reverse at an inopportune time leading them to financial ruin.
These are just three of the many behavioral tendencies that can negatively impact your financial success. The challenges of overcoming our emotions are significant and they affect all areas of financial planning. Take estate planning for example. The emotional challenges of facing the reality of death and the emotional energy needed by spouses to come to agreement on appropriate trustees, guardians, and executors for their estates often leads to the work not getting completed.
While it is hard to measure the benefit of having an objective financial advisor who understands your goals and the complexities of the decisions you face, most will agree that the discipline an advisor provides is the most valuable aspect of the relationship. Working with an advisor who understands the impact of emotions on financial decision making increases the odds that you will achieve your financial goals.