The Bogleheads' Review, Chapter 19

Welcome to the Bogleheads' October Project, Chapter 19, "Mastering Your Investments Means Mastering Your Emotions."

Let's start with a little quiz:

1.  A bat and a ball cost $1.10 in total.  The bat costs $1.00 more than the ball.  How much does the ball cost?

2.  If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

3.  In a lake, there is a patch of lilypads.  Everyday, the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

We'll come back to the answers at the end, but trust me, this relates to the my review of Chapter 19 of the Bogleheads' Guide to Investing.

When it comes to investing, we are all better off to be like Mr. Spock, above.  Emotions, at times, serve us very well.  The fight or flight reaction pumps up our adrenaline and helps us either in battle, or to get the heck out of a bad situation.  However, knowing which to do when is often when our emotions get the better of us.  Things like ego and overconfidence could be big trouble.

We are all emotional beings.  This we know.  We get excited, fearful, optimistic, depressed.  These emotions have a greater impact on our decision making than most of us would like to believe.  In the end, almost all of us, in almost everything we do make one massive error that, if applied to investing, could cost you dearly.  What is this error?

We make decisions emotionally and justify them rationally.

Think about this.  Take a break from investing for a moment.  Why do you drive the car that you drive?  How about your favorite shirt or dress?  Why does everyone at that cute little Italian place around the corner know your name?  Or the sports bar over on third?  There is an emotional reason you choose these things, and if pressed as to why, what would you say?  "They have the best marinara in town."  "The gas mileage is terrific."  "The beers are cheap."

We make decisions emotionally and justify them rationally.

The authors remind us that "when it's time to make investing decisions, check your emotions at the door. This is one area in life where acting on emotional impulses will likely lead you down a path of financial wreck and ruin."

Of course, it's not that simple.  After all, we often don't realize how much our emotions are guiding us, when, after all, we are justifying our decisions rationally.  Following, I will review the most common types of emotional roadblocks that lead to poor decision making.  Knowing this will not turn you into Mr. Spock meets Warren Buffett, but if you recognize your behavior in any of this, you may stop and think the next time your emotions are telling you, "sell, sell, sell!"

Greed and Fear

The grand-daddy of all investing emotions.  Markets go through cycles, always have.  At the peaks everyone is smart and an investment guru.  They feel euphoric over their new found riches and are excited to make more.  Maybe even "help" others make money the same way they did.  Whether it is buying tech stocks in 1999, or real estate investments in 2006, the gains lead investors to want more.  The possibility of loss is set aside.  After all, the last few stocks/condos you bought worked out great!  If the run ends, you're not going to lose money, right?  Maybe you just won't make quite as much.  Greed is running on all cylinders.

Of course, the peak comes, and the cycle resumes its downturn as it always does.  Investors run through the gamut of emotions, but ultimately somewhere near the bottom the fear that they are going to lose everything overwhelms them and they bail out.  Thus, the emotional investor buys at the top and sells at the bottom.

The authors cite a study by research firm, Dalbar.

The study found that the average mutual fund investor underperformed the S&P 500 Index by approximately 3.4 percent per year during the 19 years studied.  While part of the under-performance can be attributed to brokerage commissions, high fees and taxes, most of it's caused by investor behavior.  Thanks to greed, investors excitedly chase performance and buy when the market is up.  Thanks to fear, they panic and sell when the market is down and lock in their losses.

Economists have long studied the economic decision making of a "rational" person.  A man whom we may call Homo Economicus.  Trust me when I tell you, no such man exists.

We make decisions emotionally and justify them rationally.

Ego and Overconfidence

I have a shocker for you.  This one tends to affect men more than women.

You have heard the studies, haven't you?  70% of Americans are above average drivers, above average intelligence, appearance, etc.  Want a case in point?  In my post, After Winning the Lotto, Should You Take the Cash Value or Annual Payments? I reviewed the payout options, the tax implications, the potential emotional considerations.  In the end, I concluded, "So, I'll probably take the cash value when I win.  If you asked me what you should do, I'd probably tell you to take the payments."

Because I'm smarter than you, right?  Probably not.

This emotional bias even creeps into our research.  Certain that a stock is going to do well, or a market is going to crash, you decide to do some research before going headlong into your decision.  There is a subset of "Ego and Overconfidence" called confirmation bias.  The idea is that we tend to seek information which confirms that which we already believe and ignore information which refutes it.

Do you have a favorite sports team?  When there is negative news about your team do you tend to downplay it?  How about when your team's rival is accused of a gambling or steroids scandal?  "Suspend them all!"  "Forfeit the season!"

Want proof of confirmation bias?  Read the comments in The Housing Bubble Blog.  If you try to tell them that there is no housing bubble, you will not be treated kindly.  Tell them a story about a neighbor unable to sell his overpriced house and you will get a dozen messages patting you in the back.

We make decisions emotionally and justify them rationally.

Loss Aversion

If you lose 50% in your portfolio, you need to make 100% to get back to even.  Mathematically, losses hurt more than gains help.  Emotionally, as well, losses hurt more than gains feel good.

There are two errors that investors make in order to avoid losses.  First, they invest overly conservatively, sticking with fixed income products like CDs, bonds, or money market accounts even when a long time horizon is allowed.  Of course, the hidden opportunity cost does not hurt as much as nominal declines in portfolio value.  Thus you are "tackled from behind for walking too slowly" as Dave Ramsey would put it.

The second error caused by loss aversion is the tendency not to sell a loser when you should.  Does this contradict what I said earlier about the greed/fear cycle?  No, don't sell just because you are afraid that the sky is falling.  But sometimes a loser stock is a loser stock, and it's time to sell.  Loss aversion causes investors to resist selling, hoping that it will come back to even.  "It's not a loss until I sell" these pets.com stockholders tell themselves.

We make decisions emotionally and justify them rationally.

Paralysis by Analysis

Did you read the review of chapter 18, "Tune out the Noise," by Jonathan at My Money Blog?  This is particularly heady advice for this common problem.  Investors, gripped with fear of either losses or simply making the wrong decision don't ever cast their line.  Instead they spend day after day cutting bait.  Fear of loss or fear of making bad decisions holds us hostage as we continue to "research."

We make decisions emotionally and justify them rationally.

The Endowment Effect

We take comfort in the familiar.  Not just in food or music, but investments.  In studies of inherited portfolios it shows that people who inherit investments are more likely to keep those same investments than they are to sell them and invest in something more appropriate for themselves.  After all, the inheritance is often received from someone much older, thus more conservative.

You are also more likely to avoid foreign stocks or mutual funds or commodities funds due to unfamiliarity.

The authors give the example of over-weighting employer stock due to the obvious familiarity.  Our friend, 2million, recently sold some company stock, but still holds a large position.  I pick on him because he knows that I respect his decision making, but he is not alone in taking comfort in substantial ownership in their employer stock.  However, If given a large sum of cash, would these same employees voluntarily invest that much in their employer stock?  Not likely.  That's the endowment effect.

Following the Herd

We take comfort in numbers.  When CNBC trumpets "Dow record highs!" there is a tendency to feel safety in investing at that time.  Of course, that may be the exact opposite of what you should be doing.

Misery loves company.  When the market plummets, you may take comfort in your losses by hearing about your neighbor riding Enron all the way down to nothing.  Reality?  His losses don't help you one bit.  Forget the masses.  Do what is right for you.

We make decisions emotionally and justify them rationally.

Anchoring

Do you ever wonder why "analysts" make stock price targets?  Investors tend to place an irrational level of importance to arbitrary numbers.  A group of students were asked if the population of Namibia was greater or fewer than 500,000.  The majority correctly answered greater.  When asked to guess the actual number, the answers were typically in the 700,000 to one million range.  Another group of students were asked if the population of Namibia was greater or fewer than 50 million.  Again, the majority correctly guessed fewer.  When asked to guess the actual number, the answers were typically in the 20-40 million range.  Probably none of the students knew that the correct answer is a little over 2 million.  So, why were the guesses clustered around the number that they knew to be incorrect?  Anchoring.

Analysts look at a stock trading at $50 and say, "our price target is $90"  Does it mean anything?  Almost certainly not.  Investors buy a stock at $80 and watch it drop to $60.  They tell themselves that they will sell it at $80.  Why $80?  Does that have any significance for the stock?  No, only to the investor.

We make decisions emotionally and justify them rationally.

Financial Negligence

Three toads sit on lillypads.  One decides to jump.  How many are now sitting on lillypads?

Answer:  three.  He didn't make the jump, he just made the decision that he was going to.

Take action.  Recognize when your emotions are guiding you, but remember that, unlike Mr. Spock, we are emotional beings.  You will not completely eliminate your emotions from your decision making, but to recognize them is a huge step forward.

Perhaps, with discipline, we can learn to...

Make decisions rationally, and learn to find comfort in them emotionally.

Happy investing.

Oh, I almost forgot the answers to the quiz at the beginning: 1) 5 cents, 2) five minutes, 3) 47 days.  If you got any of them wrong, you're not alone.  Numerous students at the most prestigious universities got them wrong.  If you got them wrong it does not mean that you are doomed to a life of emotional over-reactions and poverty.  But re-read the questions.  Take your time.  Think rather than react.

Also, please buy the book, The Bogleheads' Guide to Investing

And most importantly, read my disclaimer:  This is general advice. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio.  You, alone, are responsible for any losses or damages that may and will likely result from your financial decisions.

Comments

[frankyj]

Fan-f*cking-tastic post (Pardon my french). Fortunately for me right now, I only have my target-date retirement fund for my 401(k). Hopefully, I can keep this post in mind when I have more money in the market(s).

[lamoneyguy]

Thanks Frankyj, it's one of my favorite topics. I see people getting in their own way all the time. Heck, I've been guilty of it myself plenty of times.

[Finance Buff]

Wow, what a powerful review. I like the way you linked to other blog posts for real life examples. Human irrational behaviors are so strong that we have to protect against ourselves. I have to remind myself many times over this.

[2million]

This is the best boglehead chapter review I read yet! Thanks.

Make sure your the 1st to tell me "I told you so" if I ever start complaing about the poor performance in my employer's stock ;-)

[Ranjan]

Amazing review of a financial topic. U have yr mind, body and soul into it!!

But mastering yr emotions is easier said than done. Looks fine in theory but very difficult to implement. Maybe the first step wd be to watch these emotions and observe their power. But it's a long way to any freedom from these emotions!!

[Brendan]

Couldn't have said it better myself.

http://www.catchagideon.com/2006/12/01/masting-investments-ch-19-bogleheads-series/