Confidently Beating Behavior

Confidently Beating Behavior

* This is the 4th article in a series about the Confidence Allocation*

I started this series with ten basic beliefs broken into three categories; Faith in Markets & Optimism, Knowing What You Need & What You Know, and Beating Behavior.

Listen carefully…

No matter how optimistic you are or how much you know, if you don’t behave, Mr. Market is going to punish you.  Your behavior will have a bigger impact on your wealth than anything else.

Confidence Allocation

Beyond Your Locus of Control

In his book, The Laws of Wealth, Dr. Daniel Crosby outlines 10 simple rules every investor must follow if they are to be successful.  Rule #1 is perhaps the most important: You control what matters most.

You cannot control global events and therefore have no control over prices in financial markets.  These markets are complex and dynamic systems.  They are highly susceptible to the butterfly effect, which makes reliable prediction of a globally interconnected economy impossible.  Don’t waste time trying to do the impossible.

A Better Understanding

Have you watched the news recently?  70% of headlines are related to something horrible happening.  Headlines are written to grab your attention; to make you worry.  Sometimes, as markets react to news (or no news at all), we begin checking our brokerage accounts, 401(k)’s or IRAs.  If we see them losing value, we worry more.

“Is pundit XYZ I saw on the 11 o’clock news right about this being the beginning of another financial meltdown?  I don’t want to do go through 2008 again.  What do I do?  Should I sell?  I think I’ll sell.”

When we worry, emotions weigh more on decisions than logic and that’s where mistakes happen.  This has always been a problem for investors.  Emotional mistakes can kill.  We know they can.  So why do they happen so frequently?

Well for starters, people think much differently when they are losing money than when they are making it.  There’s no getting around that.  Losing money doesn’t feel good.  But is it ok?  Brent Steenbarger wrote a great piece in Forbes about the psychological problems that affect investors.   He compared investing to decisions we have to make in life:

“The commitments that, over time, can yield considerable life satisfaction often require short-term sacrifices of what would make us happy at the moment. When our longer-term aspirations conflict with what would gratify us in the near-term, we have the makings of a cognitive/emotional mismatch.”

When there is a cognitive/emotional mismatch, we are prone to making poor decisions.  Once we agree on the premise that a large number of investment mistakes is driven by emotion, we can then try to figure out why.

To find a solution to this problem we can work backwards.  If emotions are leading to poor decisions, what then, is the cause of the emotions?  The answer to this question shows us the real problem.  It is likely that investors make poor, emotionally driven decisions because they don’t have or do not understand what their investment plan was.  They were uncomfortable, uneasy and unsure of what to do.  They lacked confidence.

This problem is solvable.  Make sure you invest in concepts you understand and believe in.  With understanding comes greater comfort.  With greater comfort comes fewer emotions and fewer emotions means a decreased likelihood of harmful decisions.  Take advantage of this.  A better education gives you an edge.

While I don’t think average investors need a deep understanding of asset classes, stock markets, and interest rates, I believe it is of paramount importance that they have a good grasp on the philosophy behind their investments. You should, with relative ease and brevity, be able to outline the ideas that guide your investment plan.

The Human Factor

Personally, the concepts of optimism and humbleness I’ve previously discussed I have the greatest degree of confidence in.  I think the global economy will continue to advance, markets will keep rewarding investors for taking risks and predicting short-term price movements is largely a loser’s game.  Over time, I’ve also gained a great deal of comfort by allocating a portion of my portfolio to the simplest, yet most influential factor that drives investment prices.  People.

There are countless factors that can influence how a market prices assets but none greater than the behavior of the market participants themselves. Despite the studies and increased awareness of human decision making, this fact is unlikely to change anytime soon.  In his book Thinking Fast and Slow, Daniel Kahneman uses the term “cognitive illusions” to explain that even though we may be aware of ways we are being irrational, it doesn’t stop us from being irrational in the future.  Psychology is a very hard thing to overcome.  It is not something that I believe will ever be arbitraged out of the marketplace.

I’m more confident in the tendency of human behavior to repeat itself than any other market statistic or correlation.  I believe cycles of fear and greed move markets up and down.  I believe in value, momentum, and trend.  In fact, I have a much easier time understanding these phenomena than understanding why East Asian emerging equity markets deserve 6.5% allocation to my portfolio.

The Confidence Factor

In the end, there are hundreds of ways to make money by investing.  Solving the cognitive/emotional response problem is a key to success.  The best advice I can possibly give is to find an investment philosophy you understand and are confident in.  The confidence factor is vastly understated.  Once you have it, when global stock markets are the top story on the evening news, you won’t have to worry.  You know what you’re doing will work and won’t waste energy questioning the “Why?” and “What if?”.

Further Reading…

Finding a Comfort Zone with Behavioral Investing

Investing in Human Behavior

The Invisible Alpha

At Ariadne, I work closely with families and individuals to organize their finances and utilize their resources to design a life they love.  If you are interested in a straightforward, no-gimmick approach to financial planning that focuses on you and your needs, don’t hesitate to get in touch.  I’d be happy to have a conversation.

Tim Brennan

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