From the November 2010 issue of Investment Advisor • Subscribe!

Our Worst Enemy

So much of the bad behavior that got us here seems stupid in its simplicity, but to which we were completely blind even last year.

I was in my car listening to afternoon drive-time, psychobabble BS when the guest said, “I don’t fix problems, I fix people.” Simple enough—people cause problems. If you want to solve problems, fix people.

I’ve quoted the following statistic a zillion times and here comes a zillion and one. Research firm Dalbar Inc. found the S&P 500 returned 12.2% in the roughly 20 years between 1984 and 2002, one of the longest bull markets in U.S. history. In contrast, the average mutual fund investor earned a paltry 2.6% during the same period. As an investing public, we seriously screwed ourselves.

“One of the assumptions economists make is that individuals are fully rational,” explains Dr. Daniel Kahneman, a professor at Princeton and 2002 Nobel laureate in economics. “If you want an easy introduction to behavioral economics, it’s economics without making the assumption that [investors] are fully rational or that they have perfect self-control.”

All of this came to mind as I sat in Dan Ariely’s keynote at FPA Denver 2010. The behavioral expert is everywhere these days and we had him on our cover in April. He also works closely with Kahneman, whom he calls Danny. Ariely ran through a number of examples of how our biases and perceptions negatively affect behavior. I couldn’t help but notice how incredibly obvious they were once pointed out. Heck, Kahneman won a Nobel Prize for telling us investors aren’t fully rational and don’t have perfect self-control. How simplistic does that sound—now?

An advisor told me a few year back she was into behavioral economics “before it was cool.” She said it in such a flippant way as to suggest she thought the concept passé, a very dangerous attitude to take for many reasons.

As part of the ongoing celebration of Investment Advisor’s 30th year, this month we look at the “present” of our “past, present, future” theme. So much of the bad behavior that got us here seems stupid in its simplicity, but to which we were completely blind even last year. It raises the question, “How can we identify irrational biases if we don’t know we have irrational biases?”

“Run experiments,” Ariely said. “Take different approaches to the same issue. Ask yourself what conclusions you base on intuition and which ones you base on research. Then doubt your intuition and run them again.”

The upside of all this is the opportunity it creates for advisors to help clients realize these biases, but only if we apply the lessons we’ve so recently learned. Given what we know of human behavior, that’s an awful big “if.”

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