NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action. If you do need help with your investments contact us.
Some content and ideas are taken from the Center for Behavioral Finance. The use of this content is not intended to be an endorsement of the Center for Behavioral Finance or Allianz Global Investors. It is used as a framework to facilitate discussion on this important topic.
I am always a little worried when an investment company talks about how to work with investors. I always worry that they are focused on selling product and not actually being helpful. While I don’t agree with everything in this report from The Center for Behavioral Finance some of the content is very useful.
Kahneman uses the framework of “two minds” to describe the way people make decisions (Stanovich and West, 2000). Each of us behaves as if we have an “intuitive” mind, which forms rapid judgments with great ease and with no conscious input; “knowing” that a new acquaintance is going to become a good friend on first meeting is one such judgment. We often speak of intuitions as “what comes to mind.”We also have a “reflective mind,” which is slow, analytical and requires conscious effort. Financial advisors engage this mind when they sit down with clients and calculate a retirement framework based on their risk profile, current circumstances and future goals.
For this discussion the Two Mind concept kinda works when describing some of the behaviors of investors. First is this comment about the “intuitive” mind.
At the core of many of these powerful but erroneous intuitions is people’s hyper-negative response to potential loss, or “loss aversion,” as described by Prospect Theory (Kahneman and Tversky, 1979). Simply put, losses loom larger than equal-sized gains.
I have seen this many times. People will buy very bad and complicated products just because they think it will keep them from loosing money. There are always risks with investing. If you lower the risk – you will likely lower the returns. If someone tells you that you can make high returns with very low risk be very careful.
This Warren Buffet quote show us the “reflective mind”.
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”
One of the reason I like Index funds is that they take away some of the anxiety of when to buy and sell stocks. The full length version of the Behavioral report had this great study.
A separate study of transactions in 19 major international stock markets produced equally salutary warnings against the urge to beat the market by too frequently buying and selling securities. Between 1973 and 2004, the average “penalty” for repeated buying and selling as opposed to a buy-and-hold strategy in these markets was 1.5 percent (Dichev, 2007).
The vast majority of investors lose money by trying to beat the market. It cannot be said enough times – use a buy and hold strategy and use ultra low cost index funds. If you don’t know how to do this you will be well served to hire a financial advisor.