In the world of behavioral finance, there are common mistakes people make that can impact their financial well-being. In today's discussion, we're going to explore nine key behaviors that often lead individuals down the wrong path in their financial decision-making. These behaviors can be seen as the "nightmare" of mistakes, as they have the potential to wreak havoc on your financial future. Branden Carney and Lou Melone of Melone Private Wealth join RJ King of D Business Magazine to discuss.
Loss Aversion: Loss aversion, is the tendency for individuals to fear losing money more than they desire gains. This instinctual behavior can make us overly cautious and risk-averse, preventing us from making informed investment decisions. Understanding that this fear is rooted in our evolutionary history and seeking guidance from a financial behavioral coach can help us avoid this trap.
Narrow Framing: Narrow framing involves making decisions without considering all the implications. This cognitive shortcut can lead to poor financial choices, such as falling for sales tactics or failing to see the bigger picture. To avoid narrow framing, it's crucial to educate oneself and work with a financial planner who can provide a comprehensive perspective on financial decisions.
Mental Accounting: Mental accounting is the practice of assigning subjective value to money based on its source or intended use. This behavior can lead to irrational financial decisions, such as overspending when using credit cards. To counter mental accounting, it's essential to treat all dollars as equal and make spending decisions based on rational financial principles.
Diversification: While diversification is often touted as a wise investment strategy, it can be deceptive when not done correctly. Merely owning multiple stocks in the same industry doesn't provide true diversification. The key is to have a well-thought-out diversification strategy tailored to your long-term goals, which should be part of a comprehensive financial plan.
Anchoring: Anchoring is the tendency to rely too heavily on the first piece of information encountered when making decisions. This behavior can lead to misguided investment choices based on initial impressions rather than careful analysis. To overcome anchoring, it's crucial to have a financial plan that anchors your investments to your long-term goals, reducing the influence of short-term market fluctuations.
Optimism: While optimism is generally seen as a positive trait, overconfidence can be detrimental in financial decision-making. Believing that everything will work out can lead to reckless investment choices. The key is to strike a balance between optimism and realism, which can be achieved through a well-structured financial plan and ongoing guidance from a financial planner.
Media Response: Media response involves reacting to news without reasonable examination. It's easy to be swayed by sensational headlines and make impulsive financial decisions. To avoid falling into this trap, it's essential to stay informed but also maintain a long-term perspective based on your financial plan rather than reacting to short-term news cycles.
Regret: Regret can be a powerful motivator, but it can also lead to emotional decision-making. Fearing future regret can cause investors to make overly cautious or risky choices. The key to managing regret is to have a well-defined financial plan that aligns with your long-term goals and to trust your financial planner's guidance.
Herding: Herding is the tendency to follow the crowd, even when it may not be in your best interest. This behavior can lead to investment decisions driven by peer pressure rather than rational analysis. To avoid herding, it's important to stick to your financial plan and avoid making impulsive decisions based on what others are doing.
Understanding and addressing these behavioral finance pitfalls is essential for making sound financial decisions. Working with a trusted financial planner who can act as a behavioral coach and guide you in creating and sticking to a comprehensive financial plan is the key to avoiding these costly mistakes. By anchoring your decisions to your long-term goals and maintaining a rational, informed approach, you can navigate the complex world of finance with confidence and resilience..
Resources:
Lou Melone's book, "Unpack Your Financial Baggage:" https://www.amazon.com/Unpack-Your-Financial-Baggage-Misconceptions/dp/1948237776
Melone Private Wealth Website: https://www.meloneprivatewealth.com/
D Business Magazine Website: https://www.dbusiness.com/
RJ: Great to see you, gentlemen.
Lou: Thanks - nice to see you and Branden.
Branden: Good to be here.
RJ: Today we’re going to talk about the mistakes people make regarding the nine behaviors in behavioral finance. Perhaps a better term would be the “nightmare” of mistakes people make and what it can potentially cost them.
Lou: Unfortunately, we hear about these situations when we’re talking with business owners and families in different gatherings. In addition, we’re continuously explaining behavioral investing/finance when meeting with our clients for reviews and our monthly communications. It’s a never-ending process acting as their behavioral coach to avoid these traps.
Branden: Not only are there traps to fall into, but it’s also incredibly easy to do so. It doesn’t matter how smart or level-headed you may think you may be – mistakes get made.It’s part of human nature. In many situations, we’re wired to fall into these traps. As we’ve discussed in prior podcasts, this wiring often goes back thousands of years and at one point was useful.
RJ: Let’s look at the nine behaviors, how people fall into the traps, and how to avoid them. The nine behaviors are…loss aversion, narrow framing, mental accounting, diversification, anchoring, optimism, media response, regret, and herding. Just hearing the list, I can tell that the behavioral lessons we’ll learn today can be applied to other parts of life – besides investing.
RJ: Let’s start with Loss Aversion. What’s Loss Aversion?
Lou: Simply put: the fear of losing $100 is mentally more painful than the hope of gaining $150. You can test yourself on your level of loss aversion in this way- What’s the smallest level of gain you require to balance out an equal chance to lose $100? Studies have found that to most people, that amount was $200, which is twice as much.
RJ: I understand the concept and can relate to it, but when you put it in those terms – I guess I don’t understand why we keep falling into the loss aversion trap? This must be rooted in people on some kind of deep level. Is loss aversion useful as a behavior at all? And where is this coming from?
Lou: Psychologists point to how our brains are wired and that over the course of our evolutionary history…protecting against losses has been more advantageous for survival than seeking gains. In addition, we’re socially conditioned to fear losing in just about everything from money to sports to board games. As a side note, loss aversion is very similar to another cognitive bias called the Endowment effect – which is people tend to assign higher value to things they already own compared to equal items they do not own. Essentially, individuals often overvalue the things they have just because they have them, regardless of their objective market value.
RJ: I suppose then, this behavior could be handy if we were still living in caves. How can we avoid loss aversion?
Branden: If we were still living in caves - loss aversion would be a useful behavior. Meaning - the fear of being eaten by a sabertoothed -tiger is better for survival than picking a berry from a plant in the Sahara. Unfortunately, this fight or flight part of the brain makes us all terrible investors. And we’ve carried that kind of fear with us for thousands of years.
In our current environment, this fear can impact how we experience losses as simple as viewing our monthly statements when it comes to our investments. For example, for many people seeing a temporary loss on their statements triggers that same fear mechanism. Then, this perceived pain starts to influence decision making - as people seek to avoid it. Their brain believes avoiding loss equals avoiding pain. As a result - the pain of loss steers them into becoming much more conservative in their decision making.
However, by trying to avoid loss and making overly conservative decisions, the investor may make worse decisions…because they may become paralyzed by the volatility of the markets. Remember that a perceived loss can’t be differentiated from a real loss by the human body – causing the body to send signals to parts of the brain to avoid loss at all costs. Going back to the example of the monthly statements, how do most investors define loss – by the day-to-day volatility that markets historically have provided. Which is incorrect – but that’s how it works.
One of the solutions is, and this will be a reoccurring theme - is to get a financial behavioral coach. This financial planner, acting as a behavioral coach, can help you refocus the brain on your plan. As in most areas, sometimes thinking rationally requires a coach.
RJ: Let’s talk about narrow framing. I believe it starts with making decisions without considering all implications.What’s an example of where people fall into this behavioral investing trap?
Lou: To expand that concept, narrow framing explains that individuals usually make decisions based on how an issue is presented, or ‘framed,’ rather than on the facts presented. It’s a cognitive shortcut to choose an option that’s more positively presented or framed.
One way to think about narrow framing is in a sales tactic that is often used: The perception in which the price of a particular item is seen to be better with a dollar-based discount—for example - $200 vs. 20%.
RJ: I have seen this tactic day in and day out – especially on appliances and computers. When it comes to investing, how do people find themselves impacted by narrow framing?
Lou: Narrow framing can come into play regarding investment products being sold by brokers or insurance agents. The best example is annuities. Agree or disagree with annuities, the way they’re framed can seem irresistible to people.
For example, people hear the following commercials/pitch about annuities like: Help build a guaranteed income stream or a retirement nest egg. Or it’s like being able to create your own pension fund. Or investors who are:seeking stable, guaranteed lifetime income and protecting you when the market goes down.
When you hear words like ‘stable, guaranteed lifetime income’ and ‘guaranteed investment stream’ and ‘protection when the market goes down’ it can be very difficult for human nature to turn an annuity down.
RJ: I would think so.Usually, you hear phrases like ‘past performance is no guarantee of future success’ and that ‘there are no guarantees when it comes to investments.’ Are annuities everything they promise?
Lou: Well - let’s stick to this idea of narrow framing first, as you can see the way these products are framed, they’re very appealing. Annuities, however, shouldn’t be judged as a stand-alone solution. Any financial plan should be based on retirement goals and the income needed in retirement. So, the entirety of the questions one should ask are: Will annuities supply the amount of income you need to live throughout your retirement years? And do you know how much money you need to live the lifestyle you want? Also, how do they measure up against all asset classes in a 20–30-year retirement plan AFTER the expenses that are built in for these Guarantees they’re offering? These are the questions to ask when you see guarantees being made – as we’re all aware, insurance companies aren’t providing these bells and whistles for Free.
RJ: I see, sometimes as they say if it sounds too good to be true – then it just may be too good to be true. I can see how it’s easy to present concepts using narrow framing that may be harmful to a retirement plan. How can people avoid narrow framing?
Branden: This behavioral investing trap is one where education and understanding investment concepts like retirement income is important. Having a financial planner, acting as coach, will allow you to see how opportunities are being framed. Also, keeping a long-term view, knowing that you have a financial plan that’s been designed with your retirement goals in mind…is probably the most important way to avoid narrow framing.
RJ: The next behavioral investing topic is one that I’m guessing everyone has absolutely found themselves struggling with numerous times. Mental accounting. I think at almost every stage of life we’ve battled mental accounting. From your piggy bank to a vacation fund to credit cards, mental accounting makes us see differences that don’t exist. Branden, tell us about it.
Branden: Most people assign subjective value to money, usually based on where it came from and how it’s intended to be used. While that approach may sound harmless and reasonable, it can work against us and leave us economically worse off.
Although every physical dollar is the same, we mentally attach a different value on each dollar…based on how it was acquired. Mental accounting is the physical connection between acquiring a dollar and in the spending of that dollar. It’s why so many people go bankrupt after winning the lottery.
Let’s get into the details of mental accounting; When you get up, go to work, and earn a dollar -then the pain associated with spending that “work dollar” becomes much more painful, so in turn most tend to spend that dollar more carefully. However, when you’re given a dollar as a bonus, a tax refund, or you win a dollar in a lottery or contest…than you don’t think of this as a dollar earned. As a result, you spend that dollar differently.
RJ: For many, I would guess seeing an actual dollar leave their wallet is more painful than spending a dollar via credit card.
Lou: Yes. Credit cards impact people in that way. We often see that people spend more using credit cards than cash. This is because of ‘pain of paying theory.’ A plastic card is less tangible than cash because one cannot visibly see the loss in money through the swipe of a card and obviously the payment is deferred. It’s why Vegas encourages credit cards or playing chips.Because it’s difficult to remember you’re spending your money when it’s a swipe of a card and therefore less painful.
Again, it’s not the same pain as pulling a physical dollar out of your wallet. As a simple example of emotional attachment - There was an interesting study regarding trying to help lower income families spend less. The families put dollars in different envelopes and then put pictures of their children on the envelope so that they then saved more. Why? There was an emotional attachment to those dollars.
When you start with the concept Branden explained: There are different values that a person places on the same amount of money, based on the pain of spending it, you can see how easy it is to get into financial trouble. And you don’t even realize you’re hard wired to do so.
RJ: How can we avoid mental accounting? I don’t want to hope I don’t win the lottery and I don’t want to hope I don’t get a bonus.
Lou: Start with the idea that money is completely interchangeable - no matter how you spend it or earn it. Each dollar is valuable. It’s not an easy process but trying to imagine that every dollar is earned, so would you pay for the same item if pulling out cash or writing a check?
RJ: Let’s talk about diversification. Generally, we hear only good things regarding diversification. We’re told to have a diverse portfolio. Branden, how can diversity be a bad thing?
Branden: Diversification can be deceptive - if you believe for example that owning multiple company’s stock in one industry means you are diversified. All those investments are exposed to the fluctuations of the industry. Simple put; Diversity through one industry is not diversity.
Lou: Living in Michigan – essentially home of the BIG 3 – I’ve come across this many times from those that work in the auto industry. To compound the issue, they not only worked in the auto industry – their income, health benefits, pension and entire plan would be tied to ONE industry. It’s been a harmless mistake – but one that could (and did for some when GM declared bankruptcy during the great recession) blow up their entire retirement.
RJ: So, diversification isn’t defined as having different stocks because different stocks in the same industry expose you to the risk in the industry. You’ve essentially concentrated your risk into an industry by owning what you think is a diversity of auto stocks. I can see how that kind of diversification can be bad. I’m sure there’re other ways.
Branden: I’ve heard Author, Nick Murray provide the definition of Diversification as, “I’ll never own enough of any one thing to make a killing in it; I’ll never own enough of any one thing to get killed by it.”
RJ: What’s the proper way to diversify?
Branden: We call it the bucket approach and it should always be tied to your comprehensive plan. This may sound like common sense, but the average investor places the “cart in front of the horse.” Partially driven by brokers/insurance agents in our industry.
RJ:What do you mean by that?
Branden: Well, in the nicest way – many advisors in our industry don’t provide comprehensive planning – they may say they do, unfortunately they don’t. What they really are providing is asset management. Nothing wrong with this - but they hide behind the cloak of planning when in actuality…just want to bring in the assets to get paid.
Lou: Yes, this is what normally happens. What’s tricky for the client is that they believe they’re getting planning advice - when the broker throws something that looks like a plan in front of them. But it’s only the carrot to get the assets.What ends up happening is that “so called plan” is never looked at again if they become a client.
RJ: Tell me about anchoring. It’s another concept that not only may impact your retirement plan but how people see retail shopping and other areas of their life.
Lou: The definition of anchoring is - when we take the familiar and extend those concepts in ways we probably shouldn’t and aren’t appropriate. Let’s talk about geese for a minute.
RJ: Geese?
Lou: Yes, Geese - In a study a scientist removed multiple eggs from a goose’s nest. When the eggs hatched, he was the “parent” they saw, while the other geese from the remaining eggs knew only their biological parent. The fascinating aspect of this was the scientists’ goslings followed him around as if it were completely natural, and when he mixed all the geese up, they would re-route themselves back to their identified “parents.” He called this imprinting.However, in humans, scientists call this anchoring.
RJ: How does this relate to human behavior?
Lou: The scientist states that we’re all bombarded in life by prices; including suggested manufacturer’s retail prices for purchases like cars, lawnmowers, local housing prices of new or used homes. He states that these are not necessarily anchors to begin with, but they become anchors in our minds once we contemplate purchasing one of those items.
This is when the anchor or “the imprint” sets itself into our mind and the decision-making process, then our mind subconsciously refers to the original anchor. And Presto, RJ...you’re now a gosling.
RJ: I didn’t think geese would come up today. It makes sense though. Through behavioral investing we can learn a lot about how we may be being manipulated by sales tactics or just our own brain, but most importantly I think the lessons are on how to avoid this behavior when it comes to your long-term financial plan.
Branden: Understanding that people can be tied to their first impressions – they may be overly anchored to facts and figures that aren’t necessarily relevant.As an example, the initial investment amount may be used to compare all future gains and losses of a portfolio, reinforcing how much future dollars will be invested.
Meaning – the money gets invested and the markets temporarily pull back (which is normal and natural), but now the investor stops investing as they were anchored to the initial amount that is now lower.They hold off due to loss aversion – when in reality, they should be adding more at better prices. If they are a longer-term investor.
The best way to avoid this? Simple. Have a plan. Anchor all investments to a long-term strategic plan that’s based on your goals, created by a certified financial planner who understands the fundamentals of retirement planning.
RJ: What about optimism? How can optimism be bad? Haven’t we always been told to be optimistic, Stay positive, Don’t dwell on the negative and Move forward? And the other 10,000 cliches. Branden, how can being optimistic be negative?
Branden: Well, considering we are talking about optimism as the belief that good things happen to me and bad things happen to others. It can be easy to see how quickly your financial plan can go off the rails with this type of outlook. The saying by Author, Morgan Housel is to save like a pessimist and invest like an optimist.
RJ: With that type of definition, I suppose bad decisions may be made easily.
Lou: Sure. Think of it this way – when you believe good things happen to you and you can’t be impacted by all the bad things that other people experience - then yes – you believe that your investing choices will always be correct.Or just eventually work out. The real issue is when that optimism borders on over-confidence…we’ve all met these individuals. They’re always certain it will work – well, until it doesn’t. However, even the Warren Buffets of the world make wrong decisions and must adjust – not just be optimistic that they’ll work.
Once again, the solution is to have a plan, a behavioral coach and meeting with them to update your plan annually. By doing so, optimism can then be reshaped to realism – as life events change.
RJ: That concept of, having a Plan, seems to be the common theme with getting past what Human Nature has embedded in our brains. Perhaps the most unavoidable behavior is media response.It’s virtually impossible to tune out the media.
Branden. It can be.The technical definition is: A tendency to react to news without reasonable examination. However, I like to think of this one with a daily routine most experience:
RJ: What you’re explaining is common, I think for most - after reading a headline or article, investors tend to be influenced by headlines and react quickly to the news.
Lou: If you don’t have a long-term plan that’s built for your lifetime, then watching the news can be a roller coaster of emotions. Which then manifest into your new plan. As a reminder from prior podcasts – the financial media is not your friend. Although they do a good job of making you believe they’re keeping you informed about what is important for you. Nothing could be further from the truth. By the way, RJ this does not include what you are providing at DBusiness Magazine.
RJ: Much appreciated, our focus is on what’s happening to businesses and those people on the Detroit area.
What about regret. We’ve all experienced regret, but when we think about regret it’s often seen as a positive reaction from which we can learn and move forward. We’re told that It’s okay to have regrets because we can reflect on what we’ve done.Business calls it ‘fail fast and have no regret.’ Lou, tell us about regret and behavioral investing.
Lou: The simple view of regret is that people treat errors of commission more seriously than errors of omission. Regret often refers to human behavior regarding the fear of regret, which stems from people anticipating regret if they make the wrong choice. It also impacts investors because it can either cause them to be unnecessarily risk-averse or it can motivate them to take risks they shouldn't.
When it comes to retirement plans, regret can factor into something as simple as – but an important planning tool of rebalancing a portfolio.
People often ask themselves: “What if I would’ve just let my winners run?” Meaning, you may regret it if the investment you own continues to go up after you sold or reduced the amount in them to rebalance your portfolio. Even though, in the long run, this rebalancing has been proven to increase an investor’s return.
This normally happens when an asset class gets to an extreme level or what we call a bubble. A prime example I recall was in 1999/2000 during the dotcom bubble or during the 2007-2009 housing bubble. In both, the fear of regret was too strong for those to rebalance (in the dotcom bubble) or sell to deleverage during the housing bubble. How’d that turn out for most?
RJ: Not very good.
Lou: Your being kind – it was a disaster for a large majority of individuals.Both believing that prices would continue to go to the moon- until they don’t.
RJ: Yeah, I was a bit kind there.Branden, how can we course correct and avoid regret?
Branden: To avoid a constant state of regret, once again work with a behavioral financial coach, have a plan, and when you talk with your planner…really discuss the plan. Meaning - understand how it was built for your longer-term goals.Although not every financial planner is a good match for every person - if you can find a planner you are comfortable with on all levels, you have a higher probability to manage the regret.It’s about you having the trust in the advisor and the plan.
RJ: Relationships matter. Trust matters. I suppose people need to look at how regret has impacted their decisions in the past and take that into account when considering a new opportunity.
Let’s talk about the ninth and last of our behaviors, herding. This one sounds like everything from peer pressure, to mob mentality and one for the pitchforks and torches crowd. Branden, why don’t you start this one.
Branden: We view herding as copying the behavior of others - even in the face of unfavorable outcomes. Simply put, going with the crowd. It can get you into trouble because you’re assuming things are good or bad only because others are doing the same. The dotcom bubble Lou mentioned earlier is a prime example of the effects of herd instinct. Also, a study, published in Behavioral Ecology and Planet Earth revealed that people are 1.5-2.5 times more likely to cross a busy road if the pedestrian next to them sets off first.
Now, this doesn’t just apply to crosswalks, humans are natural followers and often act similarly with their investments. Whether it’s fear of missing out on the next big stock or pulling out of their investments - regardless of rational data supporting the opposite.
RJ: It’s an instinct that’s a trap at all ages for so many reasons. We see it all the time. Lou, how do we steer clear of the herd?
Lou: Just go your own way by following your plan. However, the reality is that peer pressure and going with the crowd are instinctual to human nature. Because it’s instinctual, those who don't succumb to it can often feel distressed or fearful. Going back to our evolutionary history, there was strength in numbers and following the crowd provided protection and a level of comfort. If the herd is going in one direction, an individual may feel they're wrong by going the opposite way. Or they may fear being singled out for not jumping on the bandwagon. Again, historically, this is how mobs with pitchforks formed.
To help beat back the mob mentality, your behavioral financial coach can help you steer clear of the herd by refocusing you back to your long term plan – in my experience, the herd is always wrong longer term.
RJ: Avoid the herd. Seems simple enough. Today, we’ve covered nine behavioral investing mistakes people should avoid. We’ve demonstrated these behaviors with specific examples of where people have made mistakes. The best way to avoid these behaviors could be to hire a financial planner you can trust and who acts as your behavioral coach. Sometimes it’s too difficult to go it alone with the stakes so incredibly high – we’re talking about your retirement lifestyle - it may be best to hire a financial planner, build a long term plan, and listen to your coach.
Lou: Couldn’t agree with you more.
RJ: Thanks Lou, Branden what is the next podcast.
Branden: On our next podcast we will discuss the role of the financial advisor as quarterback for a client. We will talk about how the financial advisor fulfills the leadership role of a financial planning team. We’ll review the other team members someone may want to have on their financial planning team, how often the team should meet, what the team reviews with the client, and how to assemble your team. For many people, this is a new way to see financial planning so we will review the history of our industry – from stockbrokers, to traders, to large investment houses, and how many people think they may be engaged in financial planning as they try to day trade their way to riches.
RJ: Thanks, can’t wait for our next discussion.