Helping Clients Gain the Confidence to Act Rationally in their Own Best Interest
Neurologists have made extraordinary strides in understanding the physiology and behavioral attributes of the human brain. Using functional MRI technology (fMRI), researchers can now monitor and track the unique blood oxygenation and flow patterns of each person's brain and, with reasonable accuracy, predict how an individual might respond to a given verbal stimulus, at least in clinically arranged settings. Traditionally, it is understood that the brain is divided into two parts, the right side (emotional and creative activities) and the left side (logical). Beyond this, those mapping the human genome have uncovered DNA markers in an individual's genetic profile which can seemingly identify one's propensity to avoid or take risk, as well as whether one is by nature an optimist or pessimist. No doubt future findings in these disciplines will continue to add understanding of how the human brain drives us to act as we do.
Since March 2009, the end of the 2007-2009 equity bear market, and against a global background of ascending investment valuations, risk-taking investor psyches have not had to respond to market declines of any significance. But sooner or later the current investor complacency will be disturbed by a reversal of economic fundamentals and a commensurate shift in sentiment concerning the decline in their personal wealth. Then, the urge to take flight in times of extreme stress will overpower what might be a more sanguine assessment of the probabilities. In other words, when the investment market backdrop becomes decidedly unfavorable, the right side of the brain will assert its emotional force in the decision making process. Added to this will always be the media, incessantly clamoring for attention, reinforcing our visceral response to each new event with its usual at-the-moment lack of perspective or context.
Behavioral Economics Disrupts The Classical Model
Until the 1980s, economists and most in the portfolio management business were schooled in, and embraced, the classical free market economic theory of rational expectations when considering how individuals decide to allocate their scarce financial resources. Then, in the early 1980s, Nobel Laureate Daniel Kahneman and eventually Nobel Laureate Richard Thaler conducted investor and consumer research that uncovered evidence that individuals do not, and perhaps never did, rationally or optimally allocate their personal financial resources. Instead, Kahneman and Thaler discovered that when investors decide whether to save, spend, or invest, such decision processes are driven by behavioral predispositions, ingrained heuristics, and spur-of-the-moment influences often driven by the media or point of sale influences. Also in play are confirmation biases, the herd instinct, and a whole host of other, mostly subconscious drivers. This realization has given birth to the field of Behavioral Economics, its companion discipline of Behavioral Finance, and most recently, Emotional Finance.
Observing that clients might benefit from an understanding of these findings, TFC began inviting those in the burgeoning Behavioral Finance field to a number of client presentations and receptions. In 2009, we began a series of client briefings and quarterly letters focusing on the behavioral aspects of the investment equation. Weston Wellington (DFA), Charley Ellis (founder of Greenwich Associates), and Professor David Laibson (Head of Harvard's Department of Economics) held forth in open client forums discussing the importance of recognizing how our deep-seated biases drive investor decisions and outcomes.
In the early 1990s, a much-condensed summary of Investor Behavioral Characteristics was compiled and sent to clients. One of its conclusions is that, as investors, most of us contend with "such demons and enemies as pride, hubris, fear, greed, exuberance, anxiety, hope, and sometimes, if we lack the confidence to act, also inertia." That requires little alteration today.1
Although Jack Bogle was never a devoted acolyte of the Behaviorist School, in the course of his many writings on how individuals committing personal capital to the securities markets arrive at their choices, he had a few words of wisdom to add on the subject:
- "while rational expectations can tell us what will happen… they can never tell us when"
- "the greatest enemies of the equity investor are expense and emotions"
- "I know of no person who has been able to time the markets, and I know no one who knows someone who has timed the markets"
He might also have been tempted to add that the returns from current, expensive price earnings multiple growth stocks (e.g., today's high-tech issues) and cheap value stocks will most likely converge in the not too distant future. All the more reason to dispassionately re-balance portfolios periodically, back to an established fixed-mix between bonds and stocks.
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1 See TFC Client White Paper in Appendix: The Psychology of Investing: What Drives Our Personal Investment Decision Process?
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