There is a lot of talk these days about human behavior and investing. This has been an area of interest of mine for a while. While admitting I have no special skills or knowledge, other than that which I have picked up over the past 15 years of dealing with people day in and day out, I find it fascinating as well as confusing.
What makes us behave the way we do? Why do we discount some things and glom onto others? How is it we all have an almost cult-like devotion to our own advisors when we distrust the industry as a whole? Why do people wait until they are ready to roll off the job before engaging an advisor? Why do we listen to anyone and everyone who doesn’t really know anything?
Let’s begin with the almost cult-like devotion people have for their advisors. How many times have I heard things like, “I could never do that (move accounts away from) to my advisor”? Many, I can tell you. This is a classic example of a cognitive bias known as the “endowment effect.” Once we receive something, we own it. And once we own it, letting go of it feels like a loss, so we tend to hang onto it, even when we know it’s not in our best interest. It’s called loss aversion bias.
Here’s an actual incident that happened a while back. I was dealing with a very nice woman in her early 70s who told me she could never get in touch with her advisor. She was about 80% allocated in high growth, risky equities. Furthermore, they were highly concentrated in tech and healthcare, with little else. When I showed her, she became very concerned, and wanted to rectify it immediately. So, we spent a couple weeks working up a cash-flow plan that allocated about 20% to cash, 60% to guaranteed income, and 20% to growth in the market. The plan provided about 50% more income than she was getting and guaranteed it for life. She left the office thrilled and agreed to come in the next week to execute the plan.
She never came back. When I called her, she told me she had gone to speak with her previous advisor. He convinced her to stay the course. When I reminded her how risky her allocations were, she told me h e fixed that by reallocating half her holdings into bond funds, and better diversified the rest. When I pressed the matter and asked what his rationale was for his earlier recommendations, she said he responded that “I look so young, he forgot how old I was.” Then she giggled. I kid you not. She also told me he said I was ripping her off by recommending a guaranteed income annuity for the income portion of her portfolio, and she became angry with me for trying to take advantage of her.
The endowment effect and loss aversion bias can impact our investment decisions. We may have a fund or a stock that hasn’t performed well, but there is a reluctance to sell because then we are “locking in our losses.” Think about that. There well may be a better opportunity to recover the money that was lost in a poor performer, but that would mean acknowledging and feeling the loss.
Another cognitive bias, the “sunk cost” effect, is also in play here. This is what happens when you make a financial commitment, like theater tickets, and then when it comes time to go you really don’t want to. But you do anyway, so as not to “waste” the investment, when in fact your clear preference would be to give it a pass. This can also happen in business, when a decision is made to continue a losing project because of the investments already made, when it would make much more sense to cut your losses and move on.
Ever talk to someone who owns a stock from a company they work for or perhaps inherited from a parent? Often the decision to hold it or sell it is based on these factors, known as the “familiarity bias,” rather than how they perform. We often see this when people have most or all of their retirement in their company stock. Because they know something about the company, they believe they can somehow predict how the stock will perform. This one is very powerful.
The “bandwagon effect” bias is also quite powerful. It happens when people have the urge to buy into a very high market. They see other people doing well, and they want to as well. So, they buy high, and when the market begins to decline, they become reluctant to unload until they see everyone else selling. Known as the “herd mentality” it reminds me of a favorite saying, “if you follow the herd, you will be slaughtered.”
If you find yourself reluctant to make a move that deep down you know is good for you, you might want to consider these cognitive biases. We all have them, and they have a much greater hold on us than you might imagine.
Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he serves Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811 or at www.FreeToRetireRadio.com.