Many of the most recent breakthroughs in financial research have been discovered by psychologists rather than economists or investment researchers. The branch of study they’ve pioneered is known as “behavioral finance.” This was evidenced in 2002, when the Nobel Prize in Economics was given to psychologist Daniel Kahneman. The insights gained from research in behavioral finance reveal how our brains process decision making and how this can heavily impact our finances – in both helpful and harmful ways. Of the many behavioral biases that we can have, many are rooted in how we apply our attention.
As humans, we tend to avoid “headline” risks (like those on the front page of the newspaper or widely discussed in public). While this seems appropriate, this tendency often causes us to take on larger but lesser known risks. A good example of this occurred in the aftermath of September 11, 2001. Due to the “headline risk” of flying, more people opted to drive instead of fly even though air travel is much safer than driving – especially over long distances. Professor Gerd Gigerenzer, the director of the Harding Center for Risk Literacy in Berlin, estimates that an extra 1,595 Americans died in car accidents in the year after the attacks due to this tendency. Because of our poor understanding of danger, the maxim “out of the frying pan into the fire” often applies to our behavior. This holds true in our financial decisions. If the stock market crashes, it is understandable that many people don’t want their portfolios to suffer the same fate. Avoiding this risk by holding excess bonds or cash in advance may accomplish that, but at a near certain risk of their portfolio failing to generate sufficient inflation-adjusted returns. Even more, deciding amid a downturn to offload risk by selling stocks in favor of bonds or cash poses an even more significant risk to the portfolio’s recovery. It matters where we focus our attention – are we just “seeing” headline risks or are we focused on our exposure to real risks and actively working on what we can control?
Just how it’s easy to focus on “headline” risks, we also tend to commit our attention to seeking complex solutions rather than embracing simple, powerful ones. As a derivative of this behavioral bias, we often try to “outsmart” the system. A study, “The Left Hemisphere’s Role in Hypothesis Formation,” published by The Journal of Neuroscience in 2000, examined how humans and animals “guess” when certain probabilities are in place. In one experiment, 80% of the time a light would appear on the right. The remainder of the time it was on the left, but the sequence was random. Prior to each trial, the subject would predict which side the light would be on. Rats, discovering that the light on the right would appear most times, continually selected that side. On the other hand, humans tried to use frequency matching to guess when the left light would appear – with minimal success! Human subjects chose a less optimal strategy than rats because of our desire to find patterns and outsmart the system. Like in this study, we tend to overlook the simple solutions to investing intelligently. Instead, we attempt to beat the rest of the market with exotic or complex solutions.
The simple but powerful index fund doesn’t have all the bells and whistles that actively managed mutual funds tout, but they have outperformed most active managers over the past decade. According to S&P Dow Jones’s 2017 SPIVA (“S&P Indexes Vs. Active”) scorecard, 63.43% of actively managed funds invested in U.S. stocks underperformed their benchmark in 2017 – over a three-year period the number of underperforming funds jumps to 83.40% and at 10 years reaches 86.65%. In some categories, like funds invested in U.S. “small-cap” stocks, less than 5% of actively managed funds outperform their benchmark over a period of 10 years. Despite not offering all the expertise of fund managers and their bold predictions, a simple strategy for diversification – the index fund – almost always wins out. Our human desire for complexities is seen even more in the appeal of hedge funds and the way pensions and endowment funds typically invest. As a testimony to simple, powerful investing solutions, my alma mater, Carthage College, was featured in numerous articles for having better returns than Harvard’s $37 billion endowment fund over the 10-year period leading up to June 30, 2017. When asked why reliance on indexing isn’t more common among the nation’s endowments, Carthage’s endowment manager replied, “Maybe it’s too simple.”
At Boardwalk Financial Strategies, one of our goals is to help you focus your attention on the important things and not let behavioral biases negatively impact your wealth. Where we focus attention often gets the better of us: humans focus on avoiding “headline risks” (even if we take on larger but lesser known risks) and overlook simple, powerful solutions because of our desire for complex solutions. It can be hard at times to not let our impulses dictate how we invest money or handle financial decisions. But we believe focusing our attention on the things we can control – like financial planning – and utilizing an academic, data-driven (though simple) investment philosophy are ways we can help you build wealth, remove financial stress, and find the time and peace to enjoy what matters most to you in life.