Even the “best portfolio ever” is one behavioral mistake from blowing up, says Carl Richards, director of investor education for the BAM Alliance and creator of the weekly Sketch Guy column in The New York Times.
“As an industry, we need to get a lot better about helping people to behave correctly,” says Richards, adding, “The best investment portfolio, the best-designed portfolio is only as good as your ability to behave with it.”
Richards used some of his simple sketches to illustrate why people make crazy decisions around money during a recent webcast from the Investment Management Consultants Association.
“Stocks are the only thing that humans rush to buy when they’re marked up and hurry to return when they’re on sale,” Richards said during the webcast. “Can you imagine behaving that way with your new car? You show up at the Audi dealership, and you walk in and you say ‘I need a new A4 Allroad.’ And they say, ‘you’re in luck! We just marked them up 30%!’ And you say ‘Awesome, I’ll take three!’ It doesn’t happen.”
Richards discussed what he sees as three big behavioral mistakes that all humans make – but that especially affect financial decisions – and some possible solutions.
“We all get greedy when everyone else is greedy and fearful when everyone else is fearful,” Richards said. “And there’s good reasons for it. That type of behavior has kept us alive as a species but it’s terrible for us as investors.”
Here are three common mistakes that clients — and advisors — make:
1. Mistake: Confusing results with activity
So often, Richards says, advisors and clients confuse activity with results.
“How often do you get that phone call, ‘Have you seen the markets? Shouldn’t we be doing something?’” Richards said. “Confusing activity with results is one of the big mistakes that we both as advisors and as human beings, investors make.”
Solution: Understand the difference.
“Helping clients [and] first of all understanding that ourselves – that our value is not in activity,” Richards said. “We should be paid for telling people to do nothing, when doing nothing is the right thing to do. We shouldn’t be bashful about it. And helping clients understand the difference between activity and results.”
To help illustrate his point, Richards quoted Warren Buffett: “Benign neglect, bordering on sloth, remains the hallmark of our investment process.”
2. Mistake: Recency bias
According to Richards, “recency bias” (or the “recency effect”) is the idea that people take the recent past and project it indefinitely onto the future.
“This plays havoc in all sorts of ways in our financial advice that we give,” he said. “It’s not only in the market, but it’s also spending policy on an institutional level. If we had three really great years for the endowment and we raised lots of money and our donations were awesome for the last three years, we may have a tendency to think next year is going to be the same. We may make really critical decisions based on that – that recency effect.”
Richards gave an example of how recency bias could show up in individual lives as well.
“In individual lives, the way that shows up is in the annual bonus,” he said. “You get a great bonus for the last two years. You think ‘I’ll surely get a great bonus in January,’ and in November, you decide you need to move and you decide you can afford a bigger house because your bonus will make up for it – and then you don’t get your bonus.
Richards believes it’s important to pay attention to the recency effect and realize when “we’re making decisions based on a short time period.”
Solution: Remember things will change.
The only solution Richards has to the recency effect is to broaden and lengthen one’s definition of the recent past.
“I think the three most important words when it comes to making really important financial decisions are: remember, remember, remember,” Richards said. “We can lengthen our definition of the recent past because we’ve got to remember that things will change.”
3. Mistake: Confirmation bias
Because research shows that men have a harder time with confirmation bias than women do, Richards explains confirmation bias like this:
“This is the way most men make decisions: We make a decision, and then we do our research,” he said. “And our research consists of narrowly dismissing anything that disagrees with what we’ve already decided to do, and gathering evidence to support the decision we’ve already made.”
As Richards says, it’s “really, really challenging” to overcome confirmation bias.
“If you made a big investment decision on behalf of your clients tonight, and you woke up in the morning and there were two emails in your inbox. One said ’10 reasons you shouldn’t do what you decided last night’ and the other said ’10 reasons you should do it’ – you would delete one over the other, right?” Richards explained. “That’s how we make decisions. The dilemma with this, of course, is that it’s just sort of hard-wired.”
Solution: Embrace alternate views.
The solution to confirmation bias is to purposefully expose oneself to the alternate viewpoint, Richards said — which is a lot easier said than done.
“You have to do it in a way that you’re open to the idea that they may be correct,” Richards said. “Can you imagine? If you’re of a certain political persuasion? Imagine if you’re a liberal Democrat listening to Fox News, for instance, and not doing it to mock it or make fun of it, but doing it to actually say to yourself ‘I think I understand where they’re coming from.’ You don’t have to change your mind, necessarily. The goal would be to be intensely curious and be open to the idea, the remote possibility, that they may be right. Now you understand how hard this is.”
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