It's Just Money: CNNMoney.com Reader Question

I thought this question, sent to Walter Updegrave of CNNMoney.com, was very interesting. In two very brief paragraphs the reader reveals that she is tripping over virtually every stumbling block described by behavioral finance. Here's the question:

We put almost all of our money in the stock market through our adviser in 2000 and we are still down! One account he manages went from more than $80,000 down to $30,000 and now it is back to $50,000.

We originally paid this adviser 1.5 percent a year, but after we complained he lowered the fee to 1 percent. We're thinking of giving him six more months to get us back to where we were in 2000, but we don't want to take our money out at a loss. What should we do? -Linda, Rutherford, N.J.

Walter has a pretty good response, but frankly I'm not so concerned about the response. I just thought it would be an interesting case study to identify the behavioral finance pitfalls that Linda of Rutherford, N.J. wass falling prey to. Let's make it multiple choice. Which of the following apply:

Loss Aversion
Status Quo Bias (or Endowment Effect)
Gambler's Fallacy
Self Serving Bias
Cognitive Framing
Mental Accounting
Anchoring

What do you think? I think three clearly apply, you can make an argument for three others, and one doesn't apply here.

Loss Aversion. No question that Linda of Rutherford, N.J. is dealing with Loss Aversion. It's right here, "We're thinking of giving him six more months to get us back to where we were in 2000, but we don't want to take our money out at a loss." Because it's not a loss until you sell it, right? I'm sorry Linda, but whether you take your money out today, six months from now or six months ago, you have already lost money (barring some crazy short term returns).

Status Quo Bias. People find comfort in the familiar. It's why people stay in bad relationships, with significant others and financial advisers. There were unhappy enough with their 62% loss to demand a break in the fee. So their adviser shaved off a half a percent. How generous is that? "I'm sorry I lost more than 60% of your money. Tell you what, I'll reduce my fee by a half a percent." It's the same as the fear of the unknown. If you told Linda that she just won a $50,000 jackpot, and asked if she would like to hire her current Adviser to manage it, she would almost certainly decline.

Gambler's Fallacy. You could make the argument that this one applies, but I would say no. Gambler's fallacy occurs when when one holds the belief that a random event is either more or less likely to happen because it has not happened for a longer than expected period. It is the story of the coin that comes up heads seven times in a row. One guy says, "it can't happen an eighth time, it's gotta be tails!" The other guy says, "I'm not going to fight the trend. Heads it is!" If we assume that the returns (or lack of) generated by the Adviser is completely random, we can argue that this applies. If this was based on random odds, Linda may be thinking, "well, he's come up negative over and over again. He's totally due for a good year." However, I'm not prepared to assume that the Adviser's returns are random. Nor do I believe that Linda believes it.

Self Serving Bias. Self serving bias is an extension of plain ol' ego. Individuals give themselves too much credit for successes and not enough blame for failures. There is certainly some of this going on with Linda. It has been nearly seven years since she first hired the Adviser. Plenty of time to do some research and diversify her investments. Perhaps it is easier to blame the Adviser than take action to make a change.

Cognitive Framing. The way a problem is framed will influence the decisions individuals make. This probably does not apply to Linda's case. An example, if you asked a group if they would like a certain $1,000 or a 10% chance at $10,500 they are more likely to take the sure thing, despite the statistical outcome of the latter being higher. Conversely, if said that they can either lose a certain $1,000 or have a 10% chance at losing $10,500, they are more likely to play the odds, despite the statistical outcome of the former being more favorable.

Mental Accounting. No question this is at play. Mental accounting occurs when individuals group their money into distinct groups despite the fungibility of dollars. Look at her words, "One account he manages went from more than $80,000 down to $30,000." Well, what did the other accounts do? Was this the aggressive allocation, offset by more conservative investments? Viewing this money distinctly from all others has clouded her ability to recognize how it may fit within her overall plan. Maybe it's time to make a change. Or maybe this aggressive portion was the agreed upon amount for which they expressed a high risk tolerance.

Anchoring. Ding, ding, ding! When individuals over rely on a specific number in decision making, the anchor has been set and all decisions revolve around it. In this case the anchor is simply the initial investment amount. $50,000 today has nothing to do with $80,000 six or seven years ago.

That's all. Best of luck to Linda. I hope this "one account" is one of many.