Logical Thinking and Behavioral Finance

1. Logical Thinking andBehavioral Finance SRI in the Rockies October 19, 2002 Johann A. Klaassen, Ph.D.

2. Logical Thinking and Behavioral Finance Classical economic theories presume that the individual human being is fully informed and ideally rational when making economic decisions — and strong-willed enough to follow through, even on tough decisions. But recent developments in “behavioral finance” question this view …

3. Logical Thinking and Behavioral Finance • The Three Biggest Money Mistakes We Make — and Why We Make Them • Critical Thinking and the Financial Professional; or, How to Do Things with Words

4. Money Mistake #1: Living in the Past • Despite all our warnings, our clients insist on taking past performance as an indicator of future results. • This leads them to buy at or near highs, and sell at or near lows.

5. Money Mistake #1: Living in the Past • DALBAR: From 1984 through 2000, the S&P averaged 16.29% gains — but equity mutual fund investors averaged only 5.32%. • Why do we do this?

6. Money Mistake #1: Living in the Past • Human brains are tremendous trend-spotters — it only takes two or three repetitions to pick up on a simple pattern. • After hearing about three years of astonishing performance, for example, we feel confident predicting future good performance.

7. Money Mistake #1: Living in the Past • BUT: Our brains require about six repetitions to see a repeating, cyclical pattern — so we’re more likely to explain away a drop than to see it as a part of a cyclical pattern.

8. Money Mistake #1: Living in the Past • Thinking Critically: This is an example of the fallacy of “hasty generalization”: we jump too quickly from recent, short-term results to a prediction of future results.

9. Money Mistake #1: Living in the Past Q: How can we help our clients to not buy the hot stuff (or understand why we’re not doing it for them)? A: Raise two ideas: “mean regression” and “time horizon”.

10. Money Mistake #1: Living in the Past • Mean Regression and Time Horizon

11. Money Mistake #2: Safety in Numbers • Our clients often ask us to do what their neighbors’ advisors are doing – that is, they want to “follow the herd”.

12. Money Mistake #2: Safety in Numbers • When combined with MM#1, this leads to such silliness as March 2000, when 85% of all net fund inflows went into tech funds (Leuthold Group) – “I want to profit from tech, like everyone else!” • Why do we do this? Perhaps there’s a parallel with “Pascal’s Wager” (pardon the irreverence):

13. Money Mistake #2: Safety in Numbers

14. Money Mistake #2: Safety in Numbers • There’s little shame in being one of many people hit with a major loss, and there’s some (but not much) pride in being part of a big winning group. • “Regret aversion”: We really hate to have big regrets, and we know that to receive huge rewards we have to risk huge losses.

15. Money Mistake #2: Safety in Numbers • Thinking Critically:This is an example of the “appeal to the masses”, probably, with a hint of an “appeal to the consequences of belief”.

16. Money Mistake #2: Safety in Numbers Q: How can we help our clients to not run with the herd? A: First, tell them to turn off CNBC, since the constant stream of information is more likely to confuse than to help; second, create a written Investment Policy Statement to document needs and strategies.

17. Money Mistake #3: Sunk Costs Consider this scenario: Say you have $10,000 of MSFT with a cost basis of $5,000, and $10,000 of IBM with a cost basis of $20,000. Now you need $10,000 for your child’s tuition payment — what do you sell?

18. Money Mistake #3: Sunk Costs How many times has a potential client said “As much as we’d love to work with you, we can’t change anything about our investments right now – we’ve lost so much, we just can’t make any real changes until the market has come back a little”?

19. Money Mistake #3: Sunk Costs How many investors (and advisors) watched investments in Enron, WorldCom, Kmart, and all the others, slip away – unable to push the big green button and sell because of the pain “losing all that money” would cause?

20. Money Mistake #3: Sunk Costs Gary Belsky & Thomas Gilovich: We spend more money on car repairs because we’ve already spent so much on the car; we keep spending money on tennis lessons because we’ve already spent so much. We hold onto bad investments because we can’t get over how much we paid for them and can’t bear to make that bad investment ‘final.’

21. Money Mistake #3: Sunk Costs • Thinking Critically: This is probably not so much a fallacious way of thinking about our investments as it is a harmful way of NOT thinking about our investments. Perhaps we could call this kind of financial superstition a variety of “wishful thinking”.

22. Money Mistake #3: Sunk Costs Q: How can we help our clients to let go of sunk costs? A: First, ask them to ignore their past for a moment – “if you had this $1000 in cash, instead of these shares that cost you $10,000, would you buy today?” Second, establish a written selling discipline.

23. Logical Thinking and Behavioral Finance One of the key reasons that clients seek our advice in the first place is the simple fact that they recognize a need to have some “objective observer” involved in the process. If we succumb to the very errors they’re hoping we’ll help them avoid, what is our value to them?

24. Logical Thinking and Behavioral Finance How can we most effectively help our clients to avoid making these and other errors? Perhaps a class in human psychology or critical thinking at our local community college would be worthwhile. Short of that …

25. Logical Thinking and Behavioral Finance Here are three books likely to help: David C. Wilson, A Guide to Good Reasoning (McGraw-Hill) Stephen S. Carey, The Uses and Abuses of Argument (Mayfield) Wanda Teays, Second Thoughts: Critical Thinking from a Multicultural Perspective (Mayfield)

26. Logical Thinking and Behavioral Finance And I’m available for consultations, too: (800) 422-7284, x 118 johann@firstaffirmative.com

27. Logical Thinking and Behavioral Finance Questions?