By Carl Lachman, MBA, CFP®

The original presentation of this article can also be viewed on YouTube:

https://www.youtube.com/watch?v=6KIFviJS2Tk   

Are we rational when it comes to money?

No, we sure aren’t! We spend more money when we use credit cards instead of cash. 15% more! Then, we buy things we don’t need, but because we want them! We also assume the stock market will keep going up, when it is going up…and that it will keep going down, when it is going down.

When we want to spend money, we also tend to overestimate benefits and underestimate costs. As an example of this, the average person thinks that a kitchen remodel will cost $18,600, but when a kitchen remodel is actually done, the average total cost is $38,789!

We are not rational when it comes to money!

 

Why are we irrational when it comes to money?

Sometimes we make bad money decisions because we lack knowledge. At other times, we make bad money decisions because we are not very disciplined. But more often then not, we can blame our bad money decisions on the way our brains our wired. It’s biology!

 

Our brains get in the way!

Our brains are made up of three main parts: (1.) the brain stem, which controls our bodily functions like breathing and blood circulation. (2.) the limbic brain, which controls our emotions and reactions, and (3.) the neocortex, which is where we think, make decisions, and solve problems.

It’s part of the limbic brain you can blame: the amygdala. This is a small walnut in about the center of your brain that can be thought of as the control center of your emotions. Because of the amygdala, we too often make money and investing decisions with instincts, emotions, mental shortcuts, and feelings.

 

Instincts are good at jumping out of the way, but not for investing

Sure, we need instincts. When a ball is unexpectedly thrown at us and we see it in our peripheral vision, we move our head out of the way or throw our hands up to block it…and we do that without thinking! It’s wonderful! Yay, instincts!

But, when we use our instincts – our gut – to make investment decisions, it often turns out badly. John Bargh, PhD, has done research in this area and has written a book on unconscious reasoning called, “Before You Know It.” He says, “we tend to trust our gut reactions more than our rational ones because they happen so quickly, we think they must be true.”

One of our instincts is to act. We are wired to do something. It is a built-in part of our biology. In fact, people often explain their actions by saying something like, “Well, I couldn’t just sit there!”

Yet, doing a whole lot of nothing is often exactly what long-term investing is all about. Make a few boring investment decisions, then sit around and wait for years…and years…and years. Watching paint dry can be more exciting.

 

Emotions take over and drive the money car

Emotions cause poor decision making. Take anger, for instance. When was the last time you made a great decision while fuming mad? What did you do the last time you hit your thumb with a hammer? After saying unprintable words, you probably kicked something hard and unmoving! So, your thumb hurt and your foot hurt. Great decision!

When angry or fearful or disappointed or thrilled or joyful, don’t make a money decision! Rather, take a step back, let some time pass, perhaps make a list of pros and cons, then revisit the idea and make the decision when you are feeling calm. Easy to write, but hard to do. I know.

Embarrassment is an emotion. Just an emotion. Not fun, but just a feeling we have. However, as Dr. Richard Thaler, PhD of Economics at The University of Chicago writes, “What investors fear more than losing money is having to say, ‘What an idiot I am!’” Isn’t it rather crazy that we fear embarrassment more than we fear losing money?

Again, biology. The effect on our bodies from fear of financial failure and the fear of physical harm…is biologically the same! Both can cause sweating, increased heartrate, shallow breathing, clammy palms, brain freeze, and heart attacks!

We have to watch our emotions when it comes to decisions with money.

 

Mental shortcuts so we can think less

Every day, 1/4th of the calories (energy) our bodies burn is to make our brains work. Our brains take lots of energy to use. It’s no wonder that after we took a big exam at school, we went home and were tired and hungry.

Because our brains use so much energy, our bodies are always naturally trying to get us to think less! If we think less, it takes less energy. Thus, our brains use shortcuts in order to think less.

Examples of the mental shortcuts we take include the following:

1.)  Information Overload: we are only good at analyzing 5-9 variables at once. When we have too much information, we panic, freeze, and get stuck. We then go with our gut.

2.)  Confirmation Bias: we filter out information that we don’t like and concentrate on just the information that confirms our preconceived ideas.

3.)  Recency Bias: we forget the longer past and are too influenced by recent results. For instance, we may have an investment that has done well for years, but because it had a recent bad quarter, we don’t like it anymore.

4.)  Herding Bias: we like to go along with what others are doing and thinking. In junior high, it was called “peer pressure” and we wanted to fit into the group (herd). Sheep know they are safer when they are in a big group of sheep, and unconsciously we think our investments are safer if we are doing what our friends are doing.

 

The way we feel and what we are watching

You probably watch too much television, and when it comes to investments, you probably watch too many financial news shows. But are they really just the news? No, they are not. Those financial shows are a type of entertainment, just like everything else on television. Those financial shows are designed to keep you glued to your seat and endure lots of advertising.

Unfortunately, the producers of financial news shows know that a key way to keep you watching is to appeal to your emotions of greed and fear, both inextricably linked with money.

Jim Cramer, in referring to his show, says, “You can’t afford to miss it!” He is saying you will be richer if you watch it and poorer if you don’t. True? Nope.

The financial news commentators all use dramatic language to keep you watching. It’s a blood bath on Wall Street today! The financial markets are in freak-out mode! The company is too big to fail! The stock is crashing!

However, these various financial commentators are often wrong and you are wired to overreact. Dr. Thaler and his student Werner De Bondt wrote in the 1980s that “people tend to overact to unexpected and dramatic news events, driving stock prices out of whack.”

How wrong are the financial commentators? Here are some gems…

n  Jim Cramer told investors to sell investments and raise 5 years of cash in February of 2009. But the stock market bottomed less than a month later and then about tripled in the next 5 years!

n  If you had followed Fortune Magazine’s “10 Stocks for the Decade” in 2000, you would have lost half of your money by 2010!

n  CNBC commentator said Bear Stearns was fine in March of 2008, but it was bankrupt 6 days later.

n  Power Lunch commentator said Lehman Brothers was fine, but it was bankrupt 3 months later in 2008.

n  The Faber Report said Merrill Lynch was fine, but it ran out of money 5 months later and only exists today because Bank of America bought it at a huge discount.

 

What should we do to be better with money and investing?

There are six specific things that if we do them, we will be better with money and with our investments. Discipline, diversification, allocation, rebalancing, minimize costs, and accountability.

 

Discipline: follow a disciplined investment strategy

During an unrushed, quiet, calm time – not during a storm! – think through how you want to invest or use your money, then write it down. If you write down your strategy or money goals, you are 1.4 times more likely to accomplish them. The act of writing down your plan clarifies the plan, motivates you to do the plan, focuses you on your goals, reminds you of your goals, and allows you to see progress as you work your plan. During times of stock market turmoil, for instance, bring out your plan and read it.

Warren Buffett has said, “Success in investing doesn’t correlate with I.Q. Once you have ordinary intelligence, what you need is the temperament to control urges that get other people into trouble in investing.”

At Eclectic Associates, we always write a detailed financial plan for all of our new clients. To be most helpful, financial plans, investment strategies, and money goals should be specific, measurable, and attainable.

 

Diversification: you need a variety of investments

The idea of diversification is to spread out your money into investments that don’t all go up and down together. It’s the same idea as “don’t put all your eggs in one basket.” The average person will want their investment portfolio to include differing amounts of fixed income, equities, alternatives, and cash. A conservative portfolio might have lots of fixed income, while an aggressive portfolio might have lots of equities.

Make sure you really understand your investments and make sure there is real diversification. Just because you have 5 mutual funds in your portfolio does not necessarily mean that you have diversification, since each fund could actually be invested in essentially the same stocks.

 

Allocation: create a plan for the variety in your investments

There should be a plan for the relative amounts you choose to put into the variety of investments you are going to use. This plan is called your portfolio’s “allocation”. At the simplest level, an allocation could be 50% stocks and 50% bonds. A more complex allocation might break up the stock investments into 60% large cap, 20% mid cap, and 20% small cap. Bond investments might be broken up into sections of short-term, intermediate-term, and high-yield bonds. The allocation should be rather specific, since studies show it usually determines over 90% of an investment portfolio’s long-term returns and short-term volatility (Brinson, Hood, Beebower, 1986).  

 

Rebalance: get back to targets

It is important to move your portfolio back to the allocation targets at least twice a year. This is called rebalancing.

If your portfolio is 50% stocks and 50% bonds, but the stock market goes up, you might now have a portfolio that is 60% stocks and 40% bonds. To rebalance, you would sell 10% of your portfolio that is in stocks and use that money to buy bonds. After those sales and purchases, your portfolio would be back at 50% / 50%.

Rebalancing is not always easy. Usually, our advisors at Eclectic Associates can do it pretty quickly in their heads, but to make sure we get it right, we use advanced software to help us not miss anything. So, don’t be discouraged if this is hard to do by yourself. Check online in the settings of your investment account, since there might be an automatic rebalancing function you can set up to do this for you.

 

Minimize costs: save money on fees and taxes

How much is your advisor charging you each year? The industry average is around 3%. Over a 30 year period with a 6.5% annualized return, you will have about 70% more in your portfolio if you have a financial advisor that charges 1% per year instead of one that charges 3% per year.

Tax efficiency will also lead to big gains over the long-term with your investments. For most of this, the first thing we want to make sure we do is to save as much money for retirement in some sort of tax-deferred account, like an IRA, 401K, or 403B account. A good financial advisor with a CFP® certification should be completing annual tax strategies analysis for you. They should be making sure you are as tax efficient as possible.

 

Accountability: select the right sort of advisor

We all do better if we have someone helping us stick with our plans or goals. This person could be a spouse or friend, but many use a professional financial advisor. If you choose to use a professional, make sure you know (1.) How do they get paid? (2.) How much experience do they have? (3.) What is their education? (4.) Are they licensed to sell you something? (5.) Are they held to the fiduciary standard?

 

Your next steps with your money and your mind

            Although our firm is a fee-only financial planning and investment management firm, we believe it is most important to help our clients find peace of mind about their money and their future. It is not by chance that I have written on this topic of the ways that our mind gets in the way of our investing success. It is something we have always placed as a priority at Eclectic Associates.

If finances are making you anxious or keeping you up at night, call us at 714-738-0220 or visit our website at www.eclecticassociates.com to schedule a time to meet with me or one of our other fee-only financial advisors to discuss your personal situation.