Unpack Your Financial Baggage

What Is Behavioral Investing?

Episode Notes

In the first episode of our podcast, Lou Melone, CFP®, managing partner of Melone Private Wealth , sits down with RJ King, editor of D Business magazine.  And our conversation starts with the idea of behavioral investing.

Financial planning comes down to one simple question - will you outlive your money or will your money outlive you?  Lou talks about "winning the race to the wrong finish line."   He tells a story of two 85 year old men - the man who ran out of money at 80 is now in the same position as the man whose wealth lasted until 84!

The amygdala is the part of our brain that we sometimes know as "fight or flight." Believe it or not, the same instincts that had our ancestors run from saber toothed tigers now triggers us to move away from the market in times of volatility. The key is to create a financial plan and stick do it -and not give in to our emotions.

Lou cites some numbers regarding how individual investors often under-perform market returns. This is because they give in to their emotions! Even a difference of a couple percentage points in a given year will grow exponentially when compounded over time.  This is why it's important to work with an advisor.

In our next episode, we will discuss the anatomy of investor returns, including: stimulus, investor behavior, volatility, retention rate, and asset class. 


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/

Episode Transcription

Jon: Welcome to unpack your financial baggage, where we help you answer one simple question. Will you outlive your money, or will your money outlive you? Here are your hosts certified financial planner and managing partner of Melone private wealth Lou Melone. And editor of D business magazine, RJ King. 

RJ: Welcome to the unpack your financial baggage podcast.

My name is RJ king , Lou, tell us a little bit about this new podcast series.

Lou: Thanks RJ, you know, after about 27 years of advising higher net worth families, posting blogs, presenting to CPAs at conferences, and also writing a book about financial planning called Unpack Your Financial Baggage, I felt a podcast was another way to discuss financial planning. There's not a lot of solid information about the fundamentals of financial planning, but there's an overabundance of shows about stocks up and stocks down or economic forecasting of this or that. Retirement is vital to everyone, but the path to get there isn't always understood. The focus on financial planning may be the most secure way to retirement.

Some of the core elements of this podcast series and financial planning are this. At retirement a retiree's whole financial life essentially comes down to one question. Will your money outlive you? Or will you outlive your money? You see most people I meet, not only don't know what the question is. They don't know that was THE question.

RJ: Thank you. Talking about whether your money will outlive you or will you outlive your money? Can you give us an example of that? 

Lou: Yeah. sure RJ. A Non-smoking couple of average retirement age, which is 62, has a joint life expectancy of 30 years. So in plain English, that means that on average, the second person will pass at age 92.

Now at trendline inflation, which is 3%, the cost of living goes up almost two and a half times over that 30 years. So said another way, what costs $1 today will cost 2 dollars and 40 cents in the 30th year in retirement. So with that in mind, financial planning begins with the idea of, if you haven't got a plan to increase your income, about as much as your living costs are going up in retirement, then you may, without realizing it, have a plan for running out of money.

RJ: Okay. And as it relates to behavioral investing, which sounds like a complex topic, what is the headline? The shorthand about why it's so important for people to listen to this edition of the podcast? 

Lou: Well, I call it the tragedy of winning the race to the wrong finish line. The story goes kind of like this. Two older gentlemen sitting on a park bench, and they're chatting about their investment portfolios.

One says to the other, I've outperformed the market by 2% a year. Pretty impressive, yes?. Other guy says, "That's great. I've only matched the market's returns. That must be why I ran out of money. About five years ago when I was 80." First gentlemen, replies back, he says, oh, that's too bad. Hey, you know, I'm 85 years old as well.

Second guy comes back and says, oh, it must be doing pretty well when you've outperformed the market by 2% per year, right? First guy originally chimes back and he said, well, I, uh, you know, I ran out of money at 84. Well, unfortunately, as the story reveals, many retirees come to this realization too late to save themselves.

They believed that the goal or the finish line for retirement was investment outperformance. You see the average investor or retiree needs to understand the following: Accumulating enough money to retire on comfortably is a financial goal. Having an income that outlives them instead of the other way around is also a financial goal.

However, investment outperformance, whatever that means, is not a financial goal. Again, if your portfolio outperforms mine, And I run out of money when I'm 80 and you don't run out of money until you're 84. It's not going to matter much when we're both 85 sitting on this park bench without two dimes to rub together between us, which really circles back to the fundamental question.

Will you outlive your money or will your money outlive you? And the answer comes down to having a plan and understanding how behavioral investing works.

RJ: That's great advice. Tell us about the fundamentals of behavioral investing. 

Lou: Well, you know RJ, it starts with human nature and then a little tiny part of the brain and in history going as far back to believe it or not, what we would call the saber toothed tiger.

So understanding the brain should lead to a better understanding of economic decision-making. You know,our own experience as humans strongly suggests that we don't always act rationally, according to what they call standard economic theory, under the influence of strong emotions or stress, or for no reason we can consciously pinpoint.

We all agree we've all made decisions that we later regret and studies have shown that the pathway for the fear response in the brain bypasses the higher brain functions, including ones we usually associate with rationality. So basically we fear things for reasons outside our conscious rational mind.

And we do this because we have no choice. We are physiologically hardwired to do so. We're behaving, we're thinking, we're making decisions, with the emotional brain, always running in the background. So where does all this take place? It's called the amygdala. It's a small structure that's located deep within the brain and its function is the part of the brain that is essential for linking memories to fear.

And the amygdala has direct connections to that brainstem, which is really the central switchboard. For all the muscles in our body. So this neural shortcut from fear to physical movement is what allowed in the early days of man not to get eaten by that saber toothed tiger. Now, fortunately those days are gone, but the mechanism still remains.

So finally, the amygdala is the reason we're afraid of things outside of our control and controlling the way we react to certain stimuli. Or an event that causes an emotion that we see as potentially threatening or dangerous, whether it's real or perceived to be real. So specifically, to answer your question, the fundamentals of behavior investing are controlling those emotions and avoiding what I would call self-destructive behavior. And those behaviors, there's nine of them that you can avoid. And that would be loss aversion, narrow framing, mental accounting, uh, diversification, anchoring, optimism, media response, regret, and hurting. Now we're going to discuss these in detail in later podcast episodes.

RJ: That's great, Lou. What is the hardest part about following the fundamentals of behavioral investing? Where do people go wrong?

Lou: I think people often don't understand, now in my experience of providing planning for higher net worth families, is that all successful investing is goal-focused and planning, driven. Failed investing is often market focused and current event driven. Most successful investors, they act continuously on their plan while many failed investors react continually to the markets. In human nature is almost always a failed investor. The ability to create a long-term financial plan and then have the patience and the discipline to keep from blowing up that plan at some future moment of market or emotional stress is not available to an unassisted mind. 

RJ: Great. Let's talk numbers. What can all this mean to someone's retirement? And what kind of numbers are we talking about? 

Lou: Well, I think first some statistics. And not a lot of people really like the numbers, the hard numbers, but the statistics are real simple. Since 1935, it's a timeframe that almost certainly covers the lifetimes of everyone here listening. The CPI or what we call the cost of living index compounded at its longterm trend rate of 3% per year. But the dividend, just the cash income of the S& P 500 stock index compounded at about five and a half percent.

And those companies have been raising their dividends at nearly twice the inflation rate, as long as anybody listening has been alive. And here's a thought. Rising dividends are one critical way that retirees have kept their retirement incomes growing well beyond their living costs. So after planning and before, what we'll get into is called "behavioral coaching," the one key determinant of investment outcomes is the lifetime stock bond mix or what most people know as asset allocation.

So over the past 90 years or so. The long-term real compound annual return. Again, this is net of inflation of large companies, has been about 7%. The same figure for the most comparable bond index has been about 3%. So therefore the long-term investor who's chosen to own more bonds than equities in their portfolio has historically given away more than half the real return earned by those who chose to own equities. So the question has to be why would anyone do this? And the answer again is human nature. Investors are hardwired again, physiologically, to fail. I'll give an example. Falling investment values inflict twice as much mental pain is increasing values create positive emotions. 

In human nature, again, as we mentioned earlier, cannot distinguish between temporary declines and actually a permanent loss. What I mean is it can't tell the difference between actual risk or just simple everyday volatility. And furthermore, in just about every area of economic life, human nature becomes more willing to buy things when prices get lower, right?

And they hold off when those prices are increasing. For example, gas prices. Somehow with investing those characteristics become reversed. Meaning human nature believes when prices, again, stock prices are rising, risk is falling. And when prices are falling, risk is rising, which is completely inverted. Now the numbers of how all of this ties into the real returns of real investors

and I would call the real world. Since 1994, Dalbar, which is an independent research firm, they provide it's, what's called the quantitative analysis of investor behavior. I know it's a bit of a mouthful, but it's QAIB. And what it does is it measures the effects of investor decisions to buy, to sell, and switch into and out of mutual funds over a short or long period timeframe.

Now these effects are measured from a perspective of the investor and they don't really represent the performance of the investments themselves. The results have consistently shown that the average investor earns less. And in many cases, much less than mutual fund performance reports would suggest. So what am I saying?

Not only do investors underperform the markets, but they also underperform their own funds that they're in. So for example, in regards to the markets, as of the end of 2021, so December 31st, 2021, The last year, the average investor did 18%. Again, this is the average equity investor did 18%. Yet the markets did 28.

If you look over a three-year period, the average investor did 21 in the market's 26. If we go to 10 years, 13 versus 16, and over 30 years, 7 versus 10. Now you may think, well, 7% for the average investor versus 10 for the markets. That's not that big of a difference. Well, it is when you take 3% and you compound that for 30 years, that's a big number. But we will cover this topic in a lot more detail with an episode that we're going to go into next, which is going to be the anatomy of investor returns. 

RJ: Now, Lou, you mentioned behavioral coaching and spoke briefly about the role of an advisor. What is the value of having an advisor? 

Lou: You know, this is new for a lot of people. It's hard. This is why I suggest having a coach. And, I'm often asked, as you are asking now about that value. What is that value and what are the numbers and the intangibles? 

I guess what I'd like to say about it briefly is the value of an advisor, the value that an advisor provides, is in crafting a plan first. A plan that is appropriate for the client's most cherished financial goals, and then behavioral coaching during the most challenging emotional times, whether it be euphoric market tops or terrifying market bottoms.

You know, I'm not aware of any family that's capable of either of these tasks, let alone both. The advisor's fee is a fraction of their value to their clients at the peak of either of these challenging events. So the great advisors advice is literally priceless for not allowing their clients to blow up their plan.

So assuming that at least 90% of an investor's personal lifetime returns will be driven by these three things, A) the importance of a strong plan B) how much their portfolio is allocated to equities versus bonds, which we mentioned before and C) whether or not in those challenging times, they break with their plan.

RJ: Uh, Lou, we have talked about the foundations of financial planning, the fundamentals of behavioral investing, the pressure people feel. Actual numbers demonstrating the value of behavioral investing and the value of an advisor. We've covered a lot today. Uh, what is next for this series? Any closing thoughts?

Lou: Yeah. Next episode we will talk about in detail, the anatomy of investor returns. It's a model I've developed over the last 27 years in the financial planning business. The five components are the stimulus, investor behavior, volatility, retention rate, and asset class. Also, I wanted to mention our perspective and our mission here at Melone Private Wealth.

We found that clients trust Melone Private Wealth's financial planning process, because it provides peace of mind while protecting and growing their family's wealth. 

RJ: Thank you very much, Lou. Now you mentioned your book. How can people find the book for more details? 

Lou: Yeah, sure. Thanks RJ. They can go out and find it at Schuler books, which was published here in Michigan, in Grand Rapids, or you can go out to Amazon and find it. 

RJ: Lou. that was a great summary of everything that's going on in financial planning. And I look forward to the next podcast. Thank you so much. 

Lou: Thanks, RJ.

Jon: This has been he Unpack Your Financial Baggage podcast. Feel free to share this episode with someone you think it may benefit.

You can also follow our show on Apple Podcasts, Spotify, or wherever you're listening right now. To learn more about Melone Private Wealth, visit MelonePrivateWealth.com. The Unpack Your Financial Baggage podcast is produced by Jag in Detroit podcasts, Melone Private Wealth, LLC, MPW, is a registered investment advisor. Advisory services are only offered to clients or prospective clients where MPW and its representatives are properly licensed or exempt from licensure.