Thousands of years ago one of your ancient ancestors was enjoying the spoils of a recent hunting trip when suddenly a saber toothed tiger jumped out of the bush. Your cave man relative had a choice, fight off the tiger or drop the food and run. They ran….and they ran fast. The human brain is an amazing thing, it has evolved over the eons to help us survive. Most of those eons involved surviving physical threats where flight over fight was often the smart choice.
The financial “threats” we face in the 21st century are diametrically opposed to the physical threats of ancient times. Stock market crashes, unlike hungry saber toothed tigers, often present opportunities as opposed to imminent death. My very simple example here downplays the complex neurobiology of the human brain that drives us to make poor financial decisions, but the end result is the same: humans are hardwired to be poor investors.
Brief Review of Financial Neurobiology
In addition to “fight or flight”, there are a host of other documented and studied cognitive psychological human tendencies that impede our ability to be rational investors. Here is a high level list provided by the CFA Institute.
•Overconfidence and overoptimism—investors overestimate their ability and the accuracy of the information they have.
• Representativeness—investors assess situations based on superficial characteristics rather than underlying probabilities.
• Conservatism—forecasters cling to prior beliefs in the face of new information.
• Availability bias—investors overstate the probabilities of recently observed or experienced events because the memory is fresh.
• Frame dependence and anchoring—the form of presentation of information can affect the decision made.
• Mental accounting—individuals allocate wealth to separate mental compartments and ignore fungibility and correlation effects.
• Regret aversion—individuals make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome.
What is a Pea-brained Human to do?
I am by no means an expert on all of the ways our brains fail us with our finances. My opinion is that some people are wired well for today’s financial world, these lucky ones are winners of Warren Buffett’s “Ovarian Lottery.” Unfortunately, I believe the vast majority of us are vulnerable to these behavioral traps. But there is hope. As far as species go we as humans are uniquely gifted with intelligence and logic, two tools that we at engineered portfolio believe you can use to combat your cave man brain and become a successful investor. Becoming a successful investor, like most things in life, requires thoughtful planning and hard work. The below suggestions work in tandem with one another, reinforcing each other, you need them all to have a proper mind set to tackle Mr. Market. For those of you who don’t know Mr. Market go read, “The Intelligent Investor” by Benjamin Graham RIGHT NOW!
When faced with a major market correction how do you feel? As the panic sets in what are the thoughts going through your brain? What should be going through your brain is that this is normal stock market behavior and you know this because you have studied the history of the stock market! To date, the stock market has always recovered from every down turn, every depression and every panic. Sometimes it rebounds quickly, sometimes it takes decades to come back. But it always has come back. If we are the unlucky generation to see our stock markets completely crumble and be worthless it probably means we are in the midst of some kind of zombie apocalypse so you have bigger things to worry about than your portfolio. In fact your cave man brain might actually be more useful to you in this scenario!
I am not saying blindly buy and hold stocks and white knuckle your way through the ups and downs. NO! But understanding the stock market history will help you both build, adjust and stick to your plan.
Here is some basic history but I strongly urge you to read as much about stock market history as possible to arm yourself with the data you need.
- The stock market has 10% and 20% corrections VERY often.
- In the last 30 years 10% corrections have occurred an average of 2.27 times per year
- In the last 30 years 20% corrections have occurred an average of 0.73 times per year
- Stocks can be extremely over valued (optimism) or undervalued (pessimism) and prices tend to revert to a “mean”
William J. Bernstein’s “The Four Pillars of Investing“. Pillar #2 is the history of investing. It is only about 20 pages, however I recommend reading the entire book.
Benjamin Graham’s ” The Intelligent Investor.” Chapter 3 covers a century of stock market history (up to 1972). I really enjoy Jason Zweig’s offering which has Mr. Graham’s original text alongside some more modern commentary. It really shows the durability of Graham’s teachings.
Look FORWARD to a Market Crash…..WHAT?!
I should add a note to that title, look forward to AND BE PREPARED FOR a market crash. This might seem a little crazy, but this is the mindset you should have, you want to flip fear on its head. If you are a current purchaser of stocks and if you believe that in the end, the price level of the market ends up where ever it is going to end up, it is generally better for you if stock prices are lower today. This plays into knowing your history. In order to buy into a falling market you have to have confidence that the market will rebound. Also, in order to buy into a market you need money! When you have un-invested cash and you are armed with historical knowledge you start to look forward to when you can deploy that cash….you can’t wait for the market to drop!
I have two pieces of advice here:
#1 – Always have at least 10% of your invest-able assets in non stock assets (bonds, cash, gold etc). Ideally you would have 10% cash ready to deploy in a downturn. You can’t take advantage of a downturn in stocks if you don’t have the resources.
#2 – WARNING: Some people will hate this advice. It is generally a good idea to always have 6 months expenses saved in cash. If you believe your job is safe I recommend putting up to 50% of your cash reserves into the market during a correction. I would recommend putting 20% in after a 10% correction, if the market continues to fall I would put another 30% in after a 20% correction.
Automate Your Financial Life – Save!
Whether it is paying bills or saving for retirement I highly recommend automating your financial life. At this point I spend less than 5 minutes a month paying bills or transferring money, it is all automated. Inertia, distraction, fear and sometimes just laziness can get in the way of making smart financial decisions. One of the smartest financial decisions you can make is to SAVE! Don’t tempt fate, automate your savings where you can. This is one of the big benefits of employer 401(k) plans, the money comes out of your paycheck without any work on your part. If you want to fund an IRA, set up an automatic monthly transfer from your checking account, it becomes mindless. I fund my taxable Robinhood account with an automatic $100 transfer every week. If you don’t know what Robinhood is I strongly recommend you check it out as it plays into my next piece of advice, control what you can control. Fee’s are one of the biggest things you can control.
Control What You Can Control – Fees
I hate fees. This is a little off topic as far as behavioral finance is concerned, but I never want to miss an opportunity to say how much I hate fees! Any rational and logical person should want to reduce their financial fees as much as possible. You will reach your financial goals much sooner if you keep your fees low. Please have a read on the corrosive nature of investment fees in another blog I wrote.
Advice: For a taxable stock account check out Robinhood, no costs to buy or sell!
Advice: When buying mutual funds or ETFs never pay more than 0.30%, ideally pay 0.10% or less. I find Vanguard consistently offers low cost funds.
Advice: If your 401(k) plan only has high fee options, get some fellow concerned co-workers together and petition your human resources department to make improvements. They are fiduciaries for you and should be very receptive to your concerns about high fees.
Control What You Can Control – Asset Allocation
Again, this plays into understanding history. Asset allocation is the “mix” of different types of investments you hold. If you are unfamiliar with asset allocation I suggest you check out this blog. A proper asset allocation can help behaviorally on a number of fronts. First, a good asset allocation should minimize risk for a given level of return. The less risk you need to take the less likely you are to succumb to your cave man brain. Second, like understanding the market history, understanding the benefits of a good asset allocation will give you confidence and resolve through market turmoil. My partner Steve has done some amazing work on this website on really smart and unique asset allocation. Asset allocation is what an engineered portfolio is all about!
Unique Advice – Check Your Accounts at Least Weekly, Ideally Daily
This is financial blasphemy to many. The current thinking in the world is that since you have these behavioral weaknesses you should compensate for them by avoiding your finances. The thinking is that you will do something stupid if you look at them. I don’t disagree…..assuming that you look at them infrequently and if you only look at them when the financial world seems to be falling apart. This is exactly what happens. People are going through their lives: family, work, friends, vacations etc. They don’t really pay much attention to Wall Street or their investments. Then all of a sudden there is a major market correction or crash and everyone is talking about “the market”. So what do they do, they decide to see how their 401(k) is doing and they are SHOCKED at how much it has lost, they panic, they sell.
I propose a different approach. If you are armed with knowledge and logic, daily swings in the market will not phase you. More importantly, I believe that growing accustomed to the daily swings in the market will harden you for more robust corrections in the future. Again, you might be rooting for that correction so you can put some money to work! At this point in my investing life I find both up and down days rewarding. Either it feels like I made some money or I got closer to buying some stocks on sale. Win. Win.
Write It Down: Plan Your Work and Work Your Plan
I find that when I write things down they become more real and more manageable. Documenting your plan ensures complete clarity and helps keep you committed. It helps avoid the behavioral pit falls. For myself I’ve created an investment policy statement (IPS). It is five pages long and is very detailed. I signed it to cement my commitment to my plan. I have shared it with the guardian of my children in the event of my death with the expectation they will continue to execute my plan for my children. This is a serious document that you should take seriously. The elements of a good IPS include:
- Key Information/Document Goals
- Investment Goals
- Be specific
- Example of one of my goals:
- We want to provide for our children’s college education up to the cost of an in state institution, approximately $100,000 per child total (2016 dollars). First child enters college in 2027, second child leaves college in 2033.
- Investment Objectives
- Assets covered by the IPS
- Current combined Asset Value
- Update yearly
- Philosophy and Asset Class Preference
- This is a long section where I specific my preferred asset allocations for different situations and times in my life
- Account Specific Instructions
- This is for my spouse, heirs or guardians in the event of death
Advice: Create an investment policy statement (IPS). Sign it. Review it yearly, update it and sign it again. Be committed.
Our cave man brains are not going away any time soon. If we want to be successful investors we need to find a ways to short circuit the brain wiring causing us to make foolish financial decisions. This is not an issue of intellect but of perseverance. Some of the most intelligent human beings in history were terrible investors. Arm yourself with knowledge, leverage your logic and get ready to take that saber tooth tiger down.