Are You Rational or Are You Normal?

Don’t let exceptional events rule your investment strategy

The world of finance is diverse, with experts constantly inserting their opinions about which direction the market will go and how investors should handle their portfolios. With all of this, “noise,” who should you listen to, who has the “right,” answers and will they ever share those answers with you?

What if I told you that all of this conjecture was for not because all information about a security is already known and no matter what an investor does, they cannot outperform the market? Would you agree? On the other hand, what if I told you that markets are not rational but rather irrational and a security’s performance is correlated more to the headline of the day rather than its P.E. ratio or dividend yield? Well, which is it? What I have just described are the two fields of finance known as traditional (a.k.a. standard finance) and behavioral finance. Traditional and behavioral finance exist in the same arena but vary differently in doctrine. They both attempt to explain why markets, and ultimately individual investors, act the way they do with the hope of deriving some pattern to explain the phenomenon of investment performance. They are both, especially in recent years, considered to be valid schools of thought. So which one carries more weight and ultimately has a greater impact on financial markets and the way in which they move?  Stay tuned, we’ll come back to that.

Have you ever wondered why you just can’t seem to get that traumatizing event that happened to you in grade school out of your mind, when Billy Jonas stole your girlfriend and then took her to the school dance just to rub it in your face?¹ Rare events are automatically more vivid in our minds and because of that we have a tendency to overestimate their probabilities as noted psychologist and Nobel Prize winner in Economics Daniel Kahneman illustrates via his many experiments in his best-selling book about behavioral finance, “Thinking Fast and Slow.”² Just because they are rare does not mean that they should be neglected however. Take the 2008 market crash for example, for investors to completely ignore the crash simply because there were nine strong years of market performance that followed it would be a mistake. On the flip side to make the assumption that every time the market crashes in the future it will be to the same breadth and devastation as the 2008 crash would most likely be an overestimation. As Kahneman points out, the more descriptive the event the more likely we are to overweight its probability (Kahneman, D., 2011, p. 333). Like most concepts in behavioral finance being aware of our sensitivity to rare events is the best course of action to ensure that we separate rational from irrational thought.

Speaking of irrational thought, have you ever met someone with a fear of flying? Having known people with that particular affliction myself I can tell you that the rare but recent events of missing or crashing planes continues to reinforce that fear for them. No matter how many ways you approach it with them you cannot change their minds about how unlikely the event is to happen. Even when you remind them that they are statistically safer flying in a plane rather than driving in a car³ you cannot sway them. For them the significantly unlikely scenario of a plane crashing has biased them to look for alternative forms of transportation. This is not too dissimilar to the investor who has, forgive the pun, “crashed and burned,” in the stock market over and over again and now looks to, “safer,” investments like CD’s and money markets to protect them from harm when in actuality we know that long term these holdings can do more harm than good for them.

To further explore the study of behavioral finance⁴ we must discuss the concept of reversals and more specifically preference reversals which attempt to explain why not all economic thought is rational. To use a recent sports example, if someone were to ask me on a scale from 1-10 with 10 being great, how would you rate this year’s Masters? I might say it was an amazing tournament and give it a 10. However, when asked the follow-up question, how you would rate the tournament in the context of the last 50 Masters? I would then say that it was probably closer to a 7 or 8.  What happened? Nothing changed other than my reference point, yet the tournament from this new point of view somehow got worse using the same rating scale. This concept teaches us that relativity and context are very important when trying to make an investment decision.

Narrow framing, like my Masters example⁵, also has a huge impact on investment decisions because the more narrow the frame the less likely the reversal but consequently the more room for errors in judgement. We tend to think of risk in narrow frames. For example, “I don’t want to buy international stocks because that market is doing poorly right now.” When in actuality an investor who thinks in broader frames would want to include them for fear of not having a truly diversified portfolio.

Moving on, economist Richard Thaler first came up with the concept of mental accounting, whereby a person attaches different values or utilities to either current or future assets (Kahneman, D., 2011, p. 342-343).  This can impact investment decisions because people sometimes invest their money depending on how they view it not necessarily what it’s for. A good example of this is when an individual receives an inheritance and decides not to liquidate the positons simply because they were inherited even when the more prudent decision would be to liquidate them and invest them in a more suitable manner for their respective situation. Another example of mental accounting is when an investor continues to hold onto a concentrated position in their non-retirement account because they don’t want to pay the taxes associated with selling it at a gain when the risk of loss if the security fails is much higher than the loss from having to pay Uncle Sam.⁶ Mental accounting can also affect drawdown strategy for investors once they reach retirement. If investors truly took a long-term approach to investing⁷ they would realize,  rationally,⁸ that investing in more volatile markets such as emerging markets and expecting them to perform as tremendously in a one, five or even ten year timeframe as they have for the past 20 years⁹ is not only an unrealistic expectation but also an unnecessary one.

Retirement investing, as many great financial planners have pointed out, is about segmenting your money into different buckets. For those people already retired or are very close to retirement the first bucket should be invested primarily in cash or fixed income investments due to the fact that it is needed sooner and therefore cannot be afforded as much risk as buckets 2, 3, 4, etc.¹⁰, simply because high-risk investments cannot be justified for short-term needs. If you agree with this then why not have the same approach for your longer term needs? If high-risk investments cannot be justified for short-term needs it would stand to reason that low-risk investments cannot be justified for longer-term needs. No matter how many buckets you want to put your remaining investments into, the last bucket should always be your riskiest bucket with things like emerging markets stocks or small cap stocks¹¹ or put another way the last bucket that you will ever touch in retirement¹². For the vast majority of people entering retirement today this will be at a minimum 20 years into the future, which as history tells us provides much more consistent and positive results than that of one, five, and even 10 year market scenarios. This is why it never makes sense for investors to worry about what’s happening in those markets on a day-to-day basis because it has no relevancy to their long-term goals. Could you imagine a business owner with multiple business ventures expecting the same results in all of his or her different businesses regardless of the risk each business carries?¹³ Unfortunately, in this media driven, 24-hour news cycle world we live in today I find that more and more investors are asking the question, “What have you done for me lately?” of their riskiest investments. This is something traditional finance has no answer for but behavioral finance does.

When developing investment policy statements, financial planners often ask questions of investors revolving around their goals, time horizon and risk tolerance. Although the goals and time horizon of an investor’s portfolio are critical factors when trying to narrow down to an appropriate allocation (traditional finance), as research shows, the client’s risk tolerance should be considered above all else (behavioral finance). Because risk tolerance is a subjective measurement client to client it’s important to ask questions about risk to every client no matter their age or demographic. We all have an innate sensitivity to loss, however some investors can accept greater losses than others and finding that breaking point before the loss occurs could be the difference between success and failure for an investor and their financial planner. The difficulty is identifying which investors are more vs. less risk averse without further discussion. There is no definitive way¹⁴ to determine a client’s risk tolerance but there are ways of honing in on it. Questions such as; “how have you reacted when markets went down in the past,” “how do you feel about the current risk level of your portfolio,” “how much loss would you be comfortable assuming before you feel the need to sell out” could provide a good starting point.

Follow-up questions and discussion are more than likely necessary. What is clear though is that risk assessment questions wouldn’t have been asked of clients without the study of behavioral finance. Before behavioral finance investors behaviors would never have been considered as an important factor in determining a suitable recommendation.

In summation, scholars and investors alike will continue to argue about what drives markets and whether or not markets are truly rational or irrational. Where traditional and behavioral finance differ is in practicality. Traditional finance relies on the investor to maintain a disciplined, well-balanced approach to investing whereas behavioral finance realizes that investors are humans, not robots, and that as humans we are highly emotional beings who often times have difficulty seeing the forest through the trees when it comes to our investment strategy.¹⁵> As Meir Statman, professor of finance at Santa Clara University, succinctly put it, “Standard finance people are modeled as “rational,” whereas behavioral finance people are modeled as “normal.” (Statman, 1999). So which one do you want to be?

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice.

References:

• Jenkins, A. (2017). Which is Safer: Airplanes or Cars? Fortune.
• Retrieved from https://fortune.com/2017/07/20/are-airplanes-safer-than-cars/
• Kahneman, D. (2011). Thinking, Fast And Slow. New York, NY. Farrar, Straus and Giroux.
• Ricciardi, V. Simon, H. (2000). What is Behavioral Finance? Business, Education and
• Technology Journal. Fall Edition. p. 1-9.
• Statman, M. (1999). Behavioral Finance: Past Battles and Future Engagements. Association for
• Investment Management and Research. November/December. p. 18-27.

Footnotes:

1. No, just me? ok.
2. Solid book, I highly recommend it.
3. Americans have a 1 in 114 chance of dying in a car crash, according to the National Safety Council. The odds of dying in air and space transport incidents, which include private flights and air taxis, are 1 in 9,821. (Fortune, 2017)
4. Because let’s face it, it’s just more interesting
5. Sorry that’s the best I could come up with…It’s been a slow sports year
6. In my experience people will do almost anything to avoid paying taxes even it ends up costing them more money
7. As is preached by almost every Financial Planner
8. i.e. Traditional Finance
9. 2018 calendar year return -15.5% vs. 13.29% average annual return from 1999-2018 according to the MSCI Index
10. There could literally be an endless number of buckets but I’ve always been partial to the 3 bucket approach myself
11. You know, the scarier yet potentially rewarding areas of the market
12. If you even touch it at all
13. No? Me neither.
14. At least that I’m aware of
15. Hopefully, after reading this you can at least see around the trees