Why Can’t You Make Better Decisions? Ask Your Ego

As most of you probably know by now, University of Chicago professor, Richard Thaler won the Nobel prize in economics last week. Thaler is relatively young by Nobel laureate standards, and his primary field of study (behavioral finance), is somewhat controversial to many in numbers-driven financial advisory world. The idea that psychological research should even be part of economics has generated hostility for years.

So what is behavioral finance?

According to our client, Glenn Freed, Chief Investment Officer of Los Angeles-based LourdMurray, behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors (both retail and institutional), do not act in a rational manner. “Think of the moniker ‘behavioral’ as describing how and why individuals behave the way they do.”

Another of our clients, Matt Topley of Fortis Wealth in Valley Forge, PA, said “investing is a psychology game, not an IQ game.” As the old saying goes, human decisions are made with 80 percent emotion and 20 percent logic. According to Topley, the ratio is even more skewed. “After over 20 years in this business, I would say that when it comes to financial decisions, it’s 90 percent emotion and only 10 percent logic.”

A perfect example of this, said Topley is something called the “disposition effect.” That’s the all-to-common situation in which portfolio managers hold onto their losers and sell their winners. “Having spent 18 years on a trading desk,” said Topley, “I can assure you this is the primary reason why portfolio managers underperform--they can pick winners pretty effectively, but they cannot sell their losers.” 

According to Topley, our egos are a big part of the problem. Our egos are what drive the emotional difficulty of parting with a stock that you spent so much time analyzing.  “How can I be so wrong?” you ask yourself. “Eventually my thesis will prove correct.”

Wrong! said Topley.

*** Is this what you’re finding among your own clients? Take the Wealth Advisor Confidence Survey™ and see how you stack up to your peers (5 minutes, rapid results).

According to Freed, an advisor’s job is to manage both the peaks and valleys of clients’ behavioral biases. “With the bull market we are experiencing, investors start to get short-term memory lapses. In particular, greed kicks in and investors become inclined to move all their assets into equities,” said Freed. “Advisors should work with clients to extract emotions from their investment decisions and mitigate unnecessary risk.”

“Why do we think we are so good at financial decision making when the odds are stacked against us?” asked Topley. “The simple answer can be traced to ego, but ego is the ultimate enemy especially for our investment decisions. Can people in the financial services industry even evaluate their own personal financial decisions?”

According to Ryan Holiday, media strategist and best-selling author of Ego Is the Enemy, the answer is most often NO.

“One might say that the ability to evaluate one’s own ability is the most important skill of all,” wrote Holiday. “Without it, improvement is impossible. And certainly ego makes it difficult every step of the way. It is certainly more pleasurable to focus on our talents and strengths, but where does that get us? Arrogance and self-absorption inhibit growth. So does fantasy and vision,” he added.

Topley said: “One would expect hubris to be very prevalent right now due to the market’s all-time highs; but again human biases are coming into play.  The 2008 crisis left us with the biggest investing hangover in modern market history. As a result, portfolio managers are scared to death about missing the next correction instead of the hyper-bullish you usually see around equities when markets are at record highs.” 

Freed agreed. “Clearly, greed has kicked in, but some investors still can’t shake the nightmare of 2008-09 from their memories. Looking at the question from a different angle, we should ask, ‘Is the index’s standard deviation higher today?’ The answer to that question is yes! This means that an advisor has to ask clients the right questions and take them down “memory lane.” That’s why Freed reminds advisors about the importance of obtaining high-quality information about clients in order to provide them with the appropriate advice. “Profiling the client investment psyche has become harder because of the recent extreme markets and geopolitical events that the media constantly reminds us about,” added Freed.

Conclusion

“As valuations continue to rise above the top quartile, fundamental analysts can’t get their arms around being long,” observed Topley. “The problem is that they are only measuring the ‘P’ in price to earnings--the ‘E’ essentially stands for emotion. Until the money stops flowing into equities, the market will continue to move higher.

*** Is this what you’re finding among your own clients? Take the Wealth Advisor Confidence Survey™ and see how you stack up to your peers (5 minutes, rapid results).

TAGS: Richard Thaler, Behavioral Finance, Glenn Freed, LourdMurray, Matt Topley, Fortis Wealth, Ryan Holiday, Ego is the Enemy