24 Jan 2014 Self-Inflicted Investment Risks
In the last couple of Briefs we discussed Monte Carlo and how it can help a wise investor navigate the uncertainties that market swings create when they coincide with both large and small investment cash flows. We saw that wealth and lifestyle could be significantly impacted.
Timing risk is unknowable and is largely beyond our control. We can only plan for it and in so doing, mitigate it.
But there are risks that can be far more damaging, risks that we position ourselves to face, in short, self-inflicted behavioral mistakes. And the sad truth is, no one truly escapes them all the time. Our very wiring as human beings can work powerfully against us. Making matters worse is the fact that the financial services industry’s marketing machine is ever ready to capitalize on these emotional weaknesses.
The greatest risks investors face, and in fact, bring upon themselves are fear, greed, and too much information. We all understand the power that collective fear has on global markets. We experienced an historic financial devastation most recently in 2008.
Similarly we know how excessive optimism or more plainly greed, can drive markets well beyond reasonable valuation points. In a little more than a decade we have seen market bubbles inflate only to explode in growth stocks, technology stocks, value stocks, real estate, and gold to name but a few.
It is clear that where markets are concerned the herd mentality generally drives prices to extremes in both directions. But as they do, seeds of failure are planted deeply in the minds of unsuspecting investors who are left to their own emotions or worse, to financial “advisors” who would take advantage of those weaknesses as they make their investing decisions.
In my 30 year’s experience I have witnessed the narcotic effect of greed which invariably leads to the paralyzing effect of fear. As people tell me their investing stories they generally measure the cost of their mistakes in dollars or percentages. But as a financial advisor I understand that the true cost was and is much greater than they realize.
In fact they live in a financial/investing paralysis that has and most often continues to drain even minimize the potential their wealth can have on their lifestyles and those they would support. Past greed caused them to take more risk than they should have taken and the resulting losses left an imprint of fear that might unfairly jade their opinion of the capital markets, potentially for the rest of their lives.
At the extremes are the people who eagerly seek the ‘guaranteed’ income annuities promise. Unfortunately the annuity salesman will not tell them that they are insuring against less than a 5% chance of running out of money, or that the insurance company stands to profit handily from 95% of the upside potential. For a 3% or 4% guarantee they’re willing to lock themselves into a fixed lifestyle for the remainder of the long term contract.
The majority of investors who have been burned by taking too much risk in the capital markets fall along a continuum of undershooting their potential.
Because of their forced conservatism, they will no longer consider modest increases in risk or equity exposure to what could open up substantial opportunities for them and their families. It is a tragedy that most of the modern financial industry merely caters (sells) to their fears rather than counsel them beyond them.
Last and certainly not least is the curse of information. As investors, we are saturated in an unceasing flow of information. For the first time in history we must work harder to avoid it than to access it. Herbert Simon is quoted in Jonah Lehrer’s book How We Decide as saying “A wealth of information creates a poverty of attention.”
In his book Lehrer tells of a study conducted by Paul Andreassen in the 1980s on MIT business students. As Lerher reports it, “Andreasson let each of the students select a portfolio of stock investments. Then he divided the students into two groups. The first group could see only the changes in the prices of their stocks. They had no idea why the share prices rose or fell and had to make their trading decisions based on an extremely limited amount of data. In contrast the second group was given access to a steady stream of financial information. They could watch CNBC, read the Wall Street Journal, and consult experts for the latest analysis of market trends.”
Which group did better? To Andreasen’s surprise the group with less information ended up earning more than twice as much as the well-informed group being exposed to extra news. Turns out the high-information group was highly distracted. The students quickly became focused on the latest rumors and insider gossip. As a result they engaged in far more buying and selling than the low-information group. “They were convinced that all their knowledge allowed them to anticipate the market. But they were wrong” according to Andreasson.
We are emotional beings. If we expose our hard earned savings to the capital markets with no more than our emotions to guide us then we are asking for failure, or at best, sup-par results, both measurable and immeasurable.
A good financial plan recognizes our emotional shortcomings. Before the emotional moments are upon us, we have already worked out the answers to the questions that naturally arise in the moment. By integrating these answers into an investment plan and process, we become far more capable of safely navigating the storms the markets throw our way.
A good financial plan recognizes our emotional strengths in the form of goals, hopes and dreams. Without a plan that describes what you want out of life, how in the world will you recognize opportunities that will get you there sooner or bigger than you hoped? If you think of opportunity merely as a market windfall, without purpose beyond the windfall, you will find yourself squarely in the grip of fear or greed. Chances are your opportunity for further profit will soon be gone, much more your opportunity for purpose and of capturing the opportunities that otherwise would pass us by.