Do You Invest on Emotion or Logic?

As reported in the USA Today and many other media outlets, American economist Richard Thaler, a professor at the University of Chicago, won the Nobel Prize in Economics this year for his theories and contributions regarding “behavioral economics.”  Thaler’s life-long studies have revolved around how psychology and economic decision making intersect.   Thaler’s conclusions are well-known in the number of books he has written on the subject: “….that people’s emotions, biases and lack of self-control often end up hurting their bottom line.”

Do You Invest on Emotion or Logic? - Richard Thaler

Thaler’s studies have the most relevance to your money and how you use it.  In summary, Thaler contends and the data he provides supports the idea that we could be far wealthier, and much more financially safe, if we could control our emotional decision making and be more focused on the logical decisions we should be making with our money.

Sounds like Spock from Star Trek.

And Thaler makes that comparison.  He was quoted as saying:

“…it is about the way actual people behave as opposed to the way economists think people behave – (like) people who are highly rational, unemotional creatures — kind of like Spock in the Star Trek TV series… The people I study are humans that are closer to Homer Simpson.”

“We humans don’t always choose the right thing,” he continued. “Sometimes we over-eat. Sometimes we exercise too little. Many of us have trouble saving enough for retirement.”

 He is right on the money when it comes to your money.

I. How Investors Make Huge Financial Mistakes, Based on Thaler’s Theories Regarding Behavioral Economics:

  1. The ‘hot-hand’ fallacy. A classic error people make, Thaler explained in his cameo appearance in the movie The Big Short, is “thinking whatever is happening now is going to continue to happen in the future.”  “It is called the hot hand fallacy,” he said, the “basketball player who has made 5 shots in a row, somehow the team keeps feeding him the ball, because he has the ‘hot hand,’ even though statistically, the chances of making it are lower and lower each time.”   Obviously, much of the investing world was guilty of this particular behavioral shortcoming during 2008 banking crisis and the dot.com collapse.  Do we not see the same “irrational exuberance” all around us today?
  2. Believing what you own is worth more than what you don’t. Thaler uses Enron employees as the perfect example.  Advisors tell clients to not overly invest in the stocks of their own company, yet many Enron employees had up to 90% of their portfolio in Enron stock.  By 2001, the company was bankrupt and many retirement portfolios had been wiped out.  “Buy and Hold” failed in 2008.  There are other strategies, from diversification to safe-money principles, that better serve your portfolio than holding on to what you have.
  3. Mental Accounting can work against financial planning. Mental accounting is when people divide up liquidity for certain specific purposes.  The example used is the husband who has $25 budgeted for the week for coffee and incidentals.  Because he pays the bill for several co-workers, he has spent his allotted coffee money by Wednesday.  Most people then do not get coffee on Thursday and Friday since they have “spent” their budget on that item.  This is a good aspect of mental accounting.  But it can work against you as well.  The couple with $10,000.00 in the bank assume that they can then borrow $10,000.00 for unneeded items or intangible items such as an extravagant trip.  They “feel” like they have $10,000.00 in the bank, but in reality they have zero net worth since it is off-set with bad debt.

Bottom line – Thaler’s studies have produced mountains of evidence that investors too often use emotional inputs to make financial decisions that are usually wrong, and if they had instead applied logic, they would have pulled out of the market before a major correction impacted their investments.

Mr. Spock hit it right on the head:

“Humans, I find their illogic and foolish emotions a constant irritant.”

Do You Invest on Emotion or Logic?

So, what should an investor do regarding their money?  Can you possibly eliminate emotion from the decision-making process?

II. How to Take “Emotions” Out of the Investment Decision Making Process:

  1. Don’t focus on minute to minute returns. Investments with longer time-horizons or principal guarantee features can take emotion and worry out of retirement planning.
  2. Have a healthy sense of history. Black Monday 1987… Friday the 13th Mini-Crash 1989… Asian Market Crash/Global Downturn 1997… Dot.com Bubble 2000… 9/11 Crash 2001-02… Banking Crisis 2008 (really 2007-09)… Flash Crash 2010… It can’t happen to you?  It can’t happen again?  Irrational exuberance, hubris, you have lived long enough to know that some of your money should be protected right now, and that falling prone to Thaler’s “hot-hand fallacy” is a huge investment risk.
  3. Get protected now before it would be too late. Safe, simple, with a reasonable rate of return?  Sound familiar?  At some point, an investor must realize that their earnings over their work life deserves to be protected from market loss.  In 2008, many investors were wishing they had heeded safe money advice.  In principal protection investment vehicles, you get some of the gains, and more importantly, you endure none of the losses.  The principal protection investment vehicle should be a priority when you are in the 8th year of a bull market.  History says the clock is ticking.

As mentioned above, Thaler’s appearance in the movie The Big Short was cinematic genius His theories were on global display in the Banking Crisis of 2008.  The movie provides many examples of gross excess, and the few who saw the collapse coming.  What was self-evident was that as the crash approached – no one listened to those who were providing the warnings.  What’s different now?

The next market downturn may not be a crash, it may just be an old-school business cycle correction.  Either way, shouldn’t you have some or all of your portfolio protected from those market losses?  Logically, you know what you need to do. Our advisors help people protect and grow their money every single day. Give us a call at 877-912-1919.

Leave a Reply