As I worked towards my undergraduate degree in finance, then my Certified Financial Planner® designation, and finally my Masters in Financial Planning (MSFP), I was consistently taught about “Rational Choice Theory” and it its place in “Modern Portfolio Theory”. I learned that a rational investor, would always make the right decisions based on facts and statistics, not on emotions or gut reactions, and that was why markets were so efficient over the long-term. In the sterilized world of academia, it is easy to know the right thing to do: buy when prices are low, sell when prices are high, and stay invested for the long-run. Securities are bought or sold based on their fundaments, not based on our neighbor’s advice, or on an impulse driven by fear or excitement. It was armed with these theories, reinforced over many years of study, that I set off to become a financial advisor, and help people reach their financial goals through rational and unemotional planning and investing. I truly believed it was basically just a numbers game.
However, once I started working with real flesh and blood people (not so-called “rational people”), it quickly became apparent that there are very few, if any, purely rational investors out there (or financial advisors for that matter). If you stop and think about the people in your life, I am quite sure you will agree that humans tend to lead with their hearts and guts, not their rational minds. It’s actually one of the most endearing qualities of being human. We all thought the cold, calculating, ‘logical’ side of Mr. Spock was cool, but we loved him because of the irrational, emotional, ‘human’ side. A true Vulcan would make an excellent investor and surely would adhere to Rational Choice Theory. For the rest of us humans, our impetuous, impulsive nature, which tends to make us so interesting, also results in our having inherently bad investing instincts.
I was out walking recently, when a thought occurred to me which I think outlines the idea. Let’s say you are taking a hike, when you come across a large bear. The rational thing to do, according to most experts, is either to lie down and play dead, or to stand as tall as you can, and try to impress the bear with your size and ferocity. Having read your trusty wilderness guide, if you were to adhere to the laws of “Rational Choice Theory”, you would choose one of these tactics, perhaps depending on the type of bear you’re facing and how the bear seems to be acting. That sounds good on paper, but in real life, it is very hard (if not impossible) for most people to do. In reality, if confronted with this situation, most of us would do exactly the wrong (irrational) thing, which is to run for our lives! The ‘fight or flight’ mechanism in our brains that causes us to feel the need to ‘do something’ in the face of a threat, can have highly detrimental effects in certain situations. When it comes to long-term success as an investor, it can be calamitous.
What I have learned in the years since leaving school, is that in order to be a great advisor, and truly help your clients stay on track to reach their goals, you need to be good with all of the numbers and statistics and analytics, yes, but more importantly, you must be particularly good at recognizing and understanding the behavioral traps that cause investors to make bad decisions. Understanding how and why clients actually react to adversity and euphoria, and using this information and insight to help guide them to make the right (rational) decisions, is paramount in helping them achieve long-term success.
There is some good news…
While we cannot reprogram our brains or behavioral instincts in a single life time (or, in fact, in many generations), there are some steps we can take to mitigate the Pavlovian instincts, which tend to make us poor investors. The two main ways to accomplish this are, first, to understand and accept our human side, and the behavioral traits that cause us to make emotional or irrational decisions. If we know that we are likely to act irrationally, and we are able to step-back and see our behavior for what it is – an impulsive reaction to stress or exuberance – we are much more likely to be able to resist the siren’s song.
The second, and probably most important way to keep emotion out of the equation, is to have a plan, and stick with it. This is why a written financial plan is so very important and powerful. By planning for the future, and committing to paper, what we will do in any given scenario going forward, we help to eliminate the dreaded “F” word of finance and investing. The “F” word, of course, is “Feel”. As soon as we “feel” we must do something in the face of turbulence, we know that emotion, not reason, is running the show, and that creates a climate ripe for investing missteps.
As odd as it may sound, the key to solid long-term investing is never to “feel”, or more precisely, never to respond based on what we “feel”. So much time and energy in our business is spent debating what investment strategy is best, even though there are any number of approaches that can result in positive outcomes. What’s most important is that we have a strategy and we stick to it.
A good financial plan or investment plan should be considered and articulated in a time of calm, so that it may act as a beacon when emotions are running high. If we can stay focused, not on the short-term noise constantly surrounding us, but on the long-term goals we have set for ourselves, we greatly increase our chances of financial success. The key for us humans (and even half-humans) is to have a plan, and stay tethered to it, particularly when our instincts are telling us to run.