What Did The Bear Do To Your Brain?

April 22, 2009

 

Investor sentiment often is positive at highs and negative at lows. Many investors engage in a constant battle of pride, regret, fear and overconfidence which leads them down various roads to poor decision making. It's important to note that while all of these reactions are normal, they do not translate to more wealth if acted upon unrestrained. We have to understand that the odds of a particular endeavor do not change because of how we feel about the next trial or what happened to us in the previous trial. The gambler's odds do not change based on the result of his last toss of the dice or the amount he won or lost on that last toss.

Our minds may lead us to believe that we had something to do with the process in the past and that we can affect or predict the outcome going forward. This is all normal behavior that should be kept in check in order to emerge successfully from market extremes. The key is to avoid changing our risk exposures too often and for the wrong reasons.

It is best to avoid making large financial decisions while you are in an extreme emotional state (either positive or negative). When it comes to investing, written investment plans built during a calm emotional state with the assistance of a qualified adviser, who will hold you accountable, can help counter emotion-based decision making.

Plans should be made, reviewed and periodically updated with an awareness of your emotional state and they should include your financial values. Your financial values tend to be long term and rarely change, so they act as a better filter to screen financial decisions. Also, your values tend to act as a better adhesive when examining the merits of sticking to your written plans. Assessing risk tolerance periodically and considering how market and life circumstances affect you over the long run should help as well.

Investment policy documents capture your specific goals, risk tolerance assessment and financial objectives including your financial values, and provide a written analysis of the investment philosophy being implemented. The documents should outline how investment decisions are made so that there are few surprises when we head into various market conditions.

2) Mental Accounting Issues

Mental accounting is the tendency for individuals to organize and file decisions separately. You can use a mental accounting system similar to a file cabinet when tracking investment decisions. The folder contains the costs and benefits associated with a particular decision. Once an outcome is assigned to a mental folder, it is difficult to view that outcome in any other way.

For example, a person may be saving to buy a vacation home in five years in one account that earns 4%, while paying 9% on a three-year car loan. Because each goal has been classified separately the person does not see the flaw with this strategy.

You can put labels on different monies—dirty money, easy money, free money, sacred money—and treat these pools of money differently. In an economic sense, money inherited from a respected family member should be handled the same way as money received from a tax refund. Yet people are more likely to invest the inherited money in one way, usually conservatively, while the tax refund is likely to be spent or invested in another way.

Mental accounting also causes investors to view each of their portfolio holdings in isolation rather than within a total portfolio context. This practice can be very expensive over a lifetime of financial decision making because it causes investors to miss the point of modern portfolio theory, which is to view all of your assets and liabilities in combination rather than in isolation. Viewing each investment separately rather than using a portfolio and total net worth approach limits investors' ability to minimize risk and maximize return.

 

 

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