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The Science of Behavioral Finance

Whether you’re talking fitness, food or finances, when one learns to control his/her behavior, anything is possible. There are unconscious factors driving almost every financial decision you make. But learning how to rein in your unconscious behaviors, put aside biases, and choose the risk you do or don’t take is a big uphill battle.

Financial behavior is also impacted by:

  • Market Psychology
  • Power of the Masses Which Drives the Market
  • Herd Instinct
  • Fear and Greed

What do is the most important thing individuals need to know about Behavioral Finance?

I believe people need to know that learned behavior and biases play a big part in financial outcomes and that in order to be more successful and in control financially, an individual needs to consider investing and committing to both financial literacy (which is “the ability and confidence to use one’s own financial knowledge to make financial decisions” (Huston, 2010, p. 307) AND financial advice.  Literacy leads to understanding options, actions and outcomes. Investing in financial advice not only helps you overcome personal biases, advice can keep you from making knee-jerk reactions like when the market goes down and one panics. An advisor can be the steady hand in turbulent times. Research done by Dalbar, Inc., a company that studies investor behavior and analyzes investor market returns, consistently shows that the average investor earns below-average returns. For the 20 years ending December 31, 2019, the S&P 500 Index averaged 6.06% a year. The average equity fund investor earned a market return of only 4.25%.  Why is this? Investor behavior is illogical and often based on emotion and biases.

Behavioral economist Shlomo Benartzi wrote an article about this entitled…

Why Some Investors Panic. And Here’s How to Make Sure You Don’t

He starts off the article by asking the question: Are you likely to buy high and sell low during a market panic?

So here’s the bigger risk right now for investors: we’ve had a crazy long bull market and everyone is happy, but what happens when the market either suddenly tanks or worse goes into a steady, longer term decline? Will those losses people incur lead them to act in a way that will result in even bigger losses?

Mr. Benartzi says, “It doesn’t have to be that way.”

To help us understand why people may make such a potentially devasting mistake, let’s consider a very old type of bet introduced by the Nobel laureate Paul Samuelson. The bet goes like this: I’m going to flip a coin. If it lands on heads, you’ll win $200. However, if it lands on tails, you’ll lose $100. Would you accept the bet?

According to Mr. Benartzi, “If you’re like most people, you wouldn’t take the gamble. That’s because for many people the pain of losing $100 exceeds the pleasure of winning $200. Put another way, losses hurt twice as much as gains feel good, even when the potential loss is relatively small and doesn’t pose much risk. Such ‘loss aversion’ helps explain why a market correction can be so unpleasant that it leads to panic selling. We are wired to hate a portfolio full of red ink.”

Further research indicates that many investors are also sensitive to short-term losses which Mr. Benartzi and his co-researcher, Richard Thaler call “myopic loss aversion.”

People who are myopic are nearsighted, meaning they can only properly focus on things that are close by and everything in the distance is blurry.  The research duo have shown that people are very nearsighted when it comes to the performance of their investments and therefore only really able to focus the near term events, even at the risk of their long term results. These people are most at ricks for what is called “panic selling.” It’s this behavior that everyone needs to pay attention to and as a result many people want a financial advisor who can help them stay the course and not do anything rash with their investments.

As Warren Buffet has said, “Stay the course. It can be stressful when the markets tank, but don’t panic and sell off your investments just because of the latest news cycle.” And, “The most important thing to do if you find yourself in a hole is to stop digging.”

So let’s find out if you suffer myopic loss aversion. I’ll provide a written version of this assessment created by Mr. Benartzi in the blog post linked to this podcast. He co-developed it to determine whether you’re likely to buy high and sell low during a market panic. Let’s review his assessment questions and his comments on each one. Perhaps I can interview him in a future podcast:

1) In normal times, how often do you evaluate the performance of your investments?

  1. A) Daily or weekly
  2. B) Monthly or quarterly
  3. C) Annually
  4. D) Every few years
  5. E) Never

The more often you check your performance, the more likely you suffer from myopic loss aversion. That’s because you feel the pain of the losses more frequently and potentially overreact by panic selling. The problem is not necessarily the losses, but how often we mentally account for them.

2) I often set a goal but later choose to pursue a different one. Is this:

  1. A) Very much like me
  2. B) Mostly like me
  3. C) Somewhat like me
  4. D) Not much like me
  5. E) Not like me at all

This question was borrowed from the “grit” assessment developed by Prof. Angela Duckworth and colleagues. She and others have shown that grit—the willingness to persevere for a long-term goal, especially when it’s difficult—can help predict a variety of outcomes, from academic success to creditworthiness.

If you often give up on your longer-term goals, you’re probably at higher risk of selling low during a market decline. The pain of the short-term loss is going to make you give up on your long-term investment strategy.

In contrast, those who tend to stick with their goals are probably more likely to shrug off the market losses. This is akin to gritty long-distance runners ignoring the aches of their muscles so they can finish the race. It’s a useful mind-set. For most of us, investing isn’t a sprint—it’s a marathon.

3) Do you use any apps to regularly check on the performance of your investments?

  1. A) Yes
  2. B) No

Although smartphones can make investing more convenient, that convenience becomes problematic during periods of high volatility. That’s because people tend to be more impulsive and emotional on mobile devices. Prof. Shiri Melumad at Wharton has shown that smartphones lead people to generate more emotional content, while scientists at the University of Texas and University of California at San Diego have shown that simply having your mobile device nearby can reduce working memory and cognitive capacity.

The concern here is that trends can also make us more likely to sell during a panic. You no longer have to call your adviser or write an email. Instead, you can just pull your phone from your pocket and, with a few quick finger taps, liquidate those funds that have fallen in value.

What should you do if, based on this short assessment, you appear to be hypersensitive to short-term losses?

The most immediate thing you should do is not look at the market. Immediately delete all financial apps from your phone.

However, if you simply can’t resist looking at the market, then it’s important to take the following three steps to change the frame of the picture.

-Zoom out, which involves changing the format of your performance metric. If you are checking your 401(k), many financial institutions now allow you to see your account balance in terms of projected retirement income, as opposed to total wealth. Projected retirement income not only gives you the bigger picture—it’s also much less volatile in response to market swings.

Consider an investor with a $1 million portfolio, 60% in stocks and 40% in bonds. Let’s further assume that the portfolio’s stock investments have dropped 30% from their recent high, and bonds have been relatively flat. This means that the portfolio is now worth roughly $820,000. If we assume an annual withdrawal rate of 4%, just to keep the analysis simple, then retirement income went down from $40,000 to $32,800 a year, a decrease of 18%.

However, it is important to factor in Social Security benefits, as those didn’t go down. Assuming a retirement age of 66, Social Security benefits could amount to $36,000 a year, depending on your earnings history. In this case, total retirement income went down just 9% (from $76,000 to $68,800). The bigger frame shows a far less dire picture than the stock market alone would suggest.

-Frame the market decline as an opportunity, rather than a challenge. It’s not a crash—it’s a sale. I am not necessarily advocating to time the market if the Dow drops to say 15000 or 12000, as I surely don’t have a crystal ball. But the mere act of rebalancing portfolios amounts to a concrete plan to buy more stocks “on sale” as markets keep declining. Advisers should also focus their clients on rebalancing, as opposed to selling.

-Frame the market correction in terms of finding solutions, which help us get a better perspective on the practical implications of the crash.

The larger lesson here is that, by identifying those who are most sensitive to the current downturn, and helping them think broadly about their portfolio, advisors can help them worry less about the daily swings of the market. That, in turn, will prevent those investing mistakes that worsen the panic and cost people serious money. Uncertainty isn’t new. But panic hurts everyone. Great thoughts and a valuable assessment from this behavioral economist. You can look up more of his articles and research online. Lots of good stuff.

I wholeheartedly believe than a retirement advisor (who’s well versed in investments and insurance) can offer a wealth of expertise and experience that many of us lack, but desperately need in order to improve our financial outcomes.

Now I’d like to give you some tips on how people can apply Behavioral Finance assessments when making financial and investment decisions?

I believe that everyone should do a behavioral finance assessment to direct their financial decision making. The value of an assessment (whether it’s done with an advisor or a self-test) allows you to better you understand yourself. The better equipped you can be, the more appropriate the financial decisions will be. It’s all about increasing your self-awareness. With an assessment, you can learn why you make certain decisions, and understand the unconscious financial “blind spots” that might be influencing these decisions.

At Her Retirement we use software called DataPoints (free assessment here). Financial well-being is also about having the right money mindset. Mindset affects day-to-day spending, saving, and investing decisions, decisions that can make or break reaching financial goals. Backed by The Millionaire Next Door, DataPoints assesses personality so an advisor can help a client avoid behavioral pitfalls and achieve financial and life goals. For women who are closer to retirement, we use a program called RISA by Dr. Wade Pfau. RISA (Retirement Income Style Awareness), which allows us to scientifically identify a women’s retirement income personality, preferences and needs so that a proper retirement income plan can be customized for you.

Here’s a free wealth personality quiz I direct people to try: Discover Your Financial Personality | Marcus by Goldman Sachs®. There’s also one provided by Nerd Wallet: What’s Your Money Personality? Take Our Quiz to Find Out – NerdWallet

In addition to these two tools available to women who choose to work with Her Retirement, we have a software platform that helps women understand their financial gaps, risk and opportunities. We believe that once women know what they have and don’t have, and what they’ll need for retirement, their current behaviors will change for the better. The platform also fills gaps in financial literacy, planning and advice. It’s digital nudge that everyone can benefit from. It’s all about knowing more and having more.

Here’s a few behavioral tips that may help improve your financial outcomes:

  • Identify your financial inventory. Research confirms that you must know your starting point. You must identify your gaps and opportunities.
  • Track everything. Research shows that tracking can be an effective tool. Keep a daily list of how you spend your money.
  • Make one decision at a time. When people are faced with multiple, back-to-back decisions that test willpower, research suggests that willpower can easily be depleted. Space out your financial decisions instead of making too many at once and overwhelming yourself.
  • Pay yourself first on auto-pilot is the expert’s wisdom. This will prevent you from devoting limited willpower resources to deciding whether to spend or save money. Research suggests finding savings accounts which prevent you from withdrawing monies until you’ve reached your savings target.
  • Embrace the saver vs. spender mindset. Make it a challenge to see if you can become saver. Find other activities other than shopping and spending. Maybe cut up the credit cards too.
  • See advice or an advocate. Whether that’s a professional or an accountability partner/friend. Changing a behavior is hard. Sometimes we all need a coach. It might just be the best investment you make in yourself.

Thanks for listening to this week’s episode of my podcast. When you’re ready to get help with your financial behaviors, your retirement plan or getting connected to one of the retirement pros in our network, simply reach out to me at lynnt@herretirement.com. I’m here for you. Here’s to knowing more, having more, and getting her done.

Check out the podcast episode here! 

 

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