Investing Is More Than Just Picking Investments
A common theme I discuss with my clients is the fact that there's a lot more to financial planning and investing than just picking the right investments. Further, investing itself is not even primarily based on the study of finance. More than anything, investing is about how people behave with money. And guess what? It turns out that teaching good investor behavior is really hard to do! It's not as simple as pointing to a few clever equations, memorizing a formula or building an Excel spreadsheet. It's not about what you know -- it's about your actions and behaviors. The problem is that behavior is inborn and varies from person to person -- and it's part of what makes humans human! Greed and fear are pretty hard-wired in our brains.
We've all heard stories of intelligent, successful people who made horrible financial decisions and wound up broke. On the flip side, we've all heard the stories of the librarian (or teacher or janitor) who quietly amasses a small fortune through a lifetime of frugality and prudent investing. The difference isn't due to their understanding of finance. The difference is in their behaviors.
In light of the importance of investor behavior, there are several well-known biases and factors that cause most of the bad behavior in the world of investing. Let's go through a few of the big ones in the hopes of helping you avoid these errors in the future. It's not usually the case that the successful investor was best at picking winning stocks or applying sophisticated strategies. It is that the successful investor did lots of small things right and avoided big mistakes over a long period of time.
Pessimism vs Optimism
Historian Deirdre McCloskey is quoted as saying, "For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure. Yet pessimism has consistently been a poor guide to the modern economic world."
Pessimism is part of our human DNA. We've evolved to take threats much more seriously than opportunities. Our survival depended on being pessimistic!
Hearing that the world is falling apart is more compelling than saying things are slowly but steadily getting better over time. Pessimism can be mistaken for critical thinking. Optimism can be taken for naiveté.
Especially in the would of finance, pessimism often reigns supreme. This current bull market has been called the most hated bull market of all time. Yes, the markets have been on a great run, but haven't seen much euphoria in the run-up (at least until recently). Instead, this bull market has been marked by fear and distrust.
Most optimists have a positive outlook not because they think bad things don't happen. It's just that they are looking at things from the perspective of a longer time horizon. Things are improving over time, but the progress is marked by plenty of short-term bumps in the road. The short-term adversity and pain is part of the process and the price of admission required to realize long term improvements.
So one difference between optimism and pessimism is really just about the time horizon. If a short-term market downturn is the end for you, you should be pessimistic! If a market short-term downturn is just another chapter in a long book, you have every reason to be optimistic.
We humans have been making amazing progress for thousands of years. The stock markets is basically a function of irrational short-term beliefs dotting the way of an undeniably upward trend of progress. Sure, there will be lots of times to be scared along the way, but the rational bet is that optimism will generally beat pessimism. If you are looking for more reasons to be optimistic, pick up the book Factfulness: Ten Reasons We're Wrong About the World--and Why Things Are Better Than You Think by Hans Rosling.
And if you don't fully understand the human ability to adapt to situations, the world will be a pessimism-inducing nightmare! Project college tuition increases and it'll be prohibitively expensive in the not too distant future. Extrapolate an economic downturn and we'll be bankrupt before too long. These would be great reasons for pessimism if you assumed nothing would ever change or adapt. But that's not the way things work! We as humans have a long history of adapting to our circumstances and changing things for the better. To quote Morgan Housel, "It's also why every past market crash looks like an opportunity, but every future market crash looks like a risk."
Optimism is the belief that the odds of a positive outcome are in your favor over time, even when there will be bumps along the way. Most people wake up in the morning trying to make things a little better instead of looking to cause trouble. It’s not complicated. But it is a reasonable bet for most people.
Underestimating the Power of Compounding
By compounding, I'm not just talking about investment returns. I'm talking about everything! Let's start by looking at the example of the tech industry. IBM made a 3.5 megabyte hard drive in the 50s. By the 70s, they were making computers with a 70 megabyte hard drive. In the 90s, hard drives were up to 500 megabytes. From there, things exploded. The iMac came with a 6 gigabyte hard drive in 1999. By 2006, it was 250 gigs. By 2011, 4 terabytes. Then by 2017, up to 60 terabytes.
That's gigantic growth! The thing about compounding is not that it's big -- it's that it's so big we can hardly comprehend it.
The problem is that exponential growth isn't intuitive. We all tend to think linearly. But when compounding isn't intuitive, we often ignore its potential and instead focus on solving problems in other ways. We do this because it's easier than understanding the power of compounding. It's been said that one of the reasons Warren Buffet has been so successful is that he has been investing consistently for 75 years. If we could all be patient and just wait for the power of compounding, we'd be better off.
Good investing isn't just about earning the highest returns. A one time high return might just make you overconfident. It's about earning good returns over a long period of time. That's when the magic of compounding takes place, which ties back into the optimism vs pessimism discussion. It's usually that optimists are looking at a longer time horizon. And a longer time horizon gives you a lot more time for compounding to work it magic.
When thinking about what you want to accomplish in life (investing or otherwise), don’t forget that it will undoubtedly take longer than you think. Extend your time horizon and stop focusing on the coming week or quarter or year. Instead, focus on the coming decade and century.
Luck, Risk and Skill (failure to see the relationship)
It's really hard to pull apart the competing influences of luck vs skill. As human beings, we tend to attribute our successes to skill and hard work, and our failures to bad luck. And while that's definitely sometimes true, it's not always true. Some people are born into families that value education and give them every advantage as a child. Some people are born in war-torn countries where mere survival is the goal.
In the investing world, you can't believe in risk without believing in luck as well. They are two sides of the same coin. When we take a risk that goes well, the risk pays off. When we take a risk that goes badly, the risk hasn't paid off. Of course luck plays a role in that. When you swing for the fences, you might just strike out. You can increase your odds of getting ahead by taking more risk, but that also increases your odds of failure. That's the nature of risk. Be sure you understand the nature of risk (and role of luck) when choosing investments!
Being Overly Influenced Your Personal Experience
Your personal experiences make up a ridiculously minuscule part of what’s ever happened in the world. But if you are like most people, your personal experience probably makes up a very large part of how you think the world works.
Let's take an example of the decade you were born in. If you were born in 1970 the stock market went up 10x (adjusted for inflation) in your teens and 20s, the years you were forming your own baseline of knowledge and learning how the world works. If instead you were born in 1950, the same market went basically nowhere in your teens and 20s. In that case, you learned a very different lesson about how stock markets work than the person born in 1970. And if you were born during the Great Depression, you may have been scared away from investing for the rest of your life!
So people from different backgrounds often form very different views about investing, and tend to use that baseline experience when thinking about the future. As a result, they may end up disappointed and probably confounded by the choices others make, simply because your own experience informed your different baseline of understanding.
And that's a problem because the future doesn't tend to look very much like the past. The 401(K) has only been around since 1978. The Roth IRA is even newer - I was a grad student when the Roth was introduced. Personal financial advice and analysis about how Americans save for retirement today is not directly comparable to what made sense just a generation ago. Why? Because lots of things have changed.
The lesson to be learned here is to NOT assume your own personal experience is the only experience that matters. Counter this tendency by reading widely and try to check your own assumptions and biases when making investment decisions.
We humans are prone to investing errors that can derail the best-laid plans. By working with a professional advisor, you can avoid some of the biggest pitfalls investors face. As always, please drop me a line if you'd like to schedule a meeting to discuss any of this further.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Alyssa Lum, and all rights are reserved. Read the full Disclaimer.