Foot Pain

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a lifelong owner of equities would otherwise enjoy.

Daniel Kahneman, the Nobel Prize winning psychologist, spoke on the lessons of behavioral finance at an IMCA event in New York two days after this year’s Super Bowl. On the “endowment effect,” behavior related to loss aversion in which “people often demand much more to give up an object than they would be willing to pay to acquire it,” Kahneman suggested that in working with clients, recall that “people don’t like giving up things” even when they’ve only owned those things for a short time, like stocks in a portfolio.

He then spoke of hindsight, in which “an event seems predictable after the fact.” His example came from Super Bowl XLIX. “Look at the amount of credit the Patriots got after that stupid play” in which the Seahawks attempted a last-minute goal-line pass that was intercepted. If the pass had worked, he said, the commentators would have been praising the Seahawks.

“Hindsight induces us to believe we understand the world because we understand the past,” a particularly dangerous belief for advisors to exhibit, he said. Clients will “feel the pain acutely” of lost investment opportunities. He suggested that’s why so many investors, having seen an investment rise in value, will seek to buy that investment after it’s had its run. It’s also why mutual fund investors rarely profit from the full increase in a fund’s value, since they will far too often buy into and get out of funds, to their detriment.

Finally, Kahneman spoke of the issue of overconfidence, telling his advisor audience not to “trust your own confidence” and to remember that “you cannot predict the future.” Instead, “be confident in the principles and processes you use to work with people, not in what stocks, bonds or the markets will do.”