Why Smart People Make Dumb Mistakes with Their Money

Kerry Johnson

• Publisher: G&D Media
• Year: 2019
• Print ISBN: 9781722501976
• eBook ISBN: 9781722522964
• Topic: Personal Development
• Subtopic: Investments & Securities

Why do investors constantly chase returns? Why do they buy mediocre investments that underperform the indexes? Why do they leave their money in investments that lose money yet are unwilling to sell until they increase in value? If you can understand your own behavior with money, you will become a much better investor and earn returns that will last your whole life. Now Kerry Johnson explains why investors (possibly your clients) make such poor decisions with their money.

You will learn:

• How overconfidence bias creates poor investment decisions.
• How the endowment effect stops you from selling bad investments.
• How sunk cost fallacy causes you to own investments until they are worthless.
• How status quo bias makes change more difficult.
• How framing and anchoring motivates you to spend more.
• The seven steps in picking an outstanding financial advisor.
• The five critical concepts in creating a successful portfolio.

Kerry L. Johnson, MBA, Ph.D. , America's Business Psychologist, is a bestselling author and internationally sought after speaker with an upbeat, entertaining style, much like his writing. He travels 8,000 miles each week speaking around the world, and also heads a personal coaching company, Peak Performance Coaching.

THIRTY-EIGHT

How Do I Turn Bias into Profit?

A lot of research shows investors tend to exit or enter the market at exactly the wrong times. They often buy right after a dramatic increase in market value and sell after a substantial stock market decrease. Warren Buffett once said contrarian investing is always the right path. Being greedy when others are fearful, and fearful when others are greedy is extremely difficult, no matter who you are. If you decide to use a financial advisor, rationally tell the planner to be assertive in defending his recommendations. Let him know that you value his advice. But you will be emotional and sometimes even tell the advisor what portfolio changes to make.

You will often be wrong.

This is the start of a mature investment mindset.

You are emotionally attached to your money and will usually make the wrong decisions. But your financial advisor is focused on your goals instead of your emotions.

A good advisor will be supportive, but also cogently advise a non-emotional path.

One of my financial advisor coaching clients once told me a story of one of his clients, who lost nearly 45% of their assets in 2008. In February 2009, the client lost so much of their retirement, they were frightened about running out of money during their later years. The financial advisor told him the portfolio was well diversified and balanced. The portfolio was based on the rule of 100, meaning that the age of the client was in safe investments and the balance from their age to 100 was in more risky equities. The adviser knew the market would come back. If the investments did not recover, there would be bigger fish to fry, meaning the US economy would never recover as well.

The client insisted on taking all their money out of the stock market, but the financial advisor held his ground.

It would’ve been very easy for an advisor to just execute the client’s wishes. But the client was acting emotionally while the advisor focused on investment goals and past stock market behavior. He told his client if they wanted to sell their positions, they would also have to look for a new financial advisor. After a display of more emotion, the client backed off. It was a good thing he did. On March 9 of 2009, the market recovered bouncing to a 26% return for the rest of the year. Acting emotionally is always a bad idea.

Another idea is to turn off the TV. Financial shows like CNBC, Bloomberg, and Fox Business, are what one of my clients call, financial pornography. They make their money by sensationalism to boost ratings hour by hour. They often pump up stories that will only scare their viewers into making financial mistakes.

But a great financial advisor will call you every few months, giving you a market update. This will add context to the day-to-day craziness you will hear as an investor. Most of the sharpest brokers know that company earnings drive the stock market. Yet when CNBC talks about economic issues in Europe, slow growth in China, and a well known company taking a fall because of poor accounting procedures, it makes viewers think they should sell their investments and wait for calmer waters. But that is what these channels will communicate every day. Turn off the TV, and call your advisor. She will help you keep your emotional head on straight Investment Cycle Emotion

There are two cycles critical in making any investments.

One is the Business Cycle, and the other the Sentiment Cycle. Like a rising curve, the Business Cycle starts with movement to a peak followed by a downward slope towards recession. This is followed by a trough at the bottom moving again up to expansion as the cycle repeats. Both of these cycles are in the study guide included in this program.

The Sentiment Cycle follows the same curve. It starts with optimism, moving up to excitement, moving up to thrill, then higher to euphoria. After that, the downward part of the curve starts with anxiety moving down to denial, further down to fear, followed by desperation, moving down to panic, further to capitulation, bottoming out with despondency, and depression.

That bottoming process then starts an upward slope to hope, relief, and optimism starting the cycle over again.

While wrongheaded emotional decisions can be made at any part in the curve, the worst decisions are usually made at desperation, panic, capitulation, despondency and depression.

As the Business Cycle moves down past recession, settling on the trough, experienced investors buy. Because they know emotional investors during that part of the business cycle will feel fear, desperation, panic, capitulation, despondency, and depression. This is where expert, professional investors gain their biggest returns. But the opposite is true at the top of the Business Cycle curve. Starting with the upward movement of expansion, followed by the peak, gives expert investors a signal to sell. Experts know emotional investors will feel optimism, excitement, thrill, followed by euphoria at the top.

Before Federal Reserve Chairman Ben Bernanke, was Federal Reserve Chairman Alan Greenspan.

Greenspan called the euphoria peak, irrational exuberance.

He was aware of how emotional investors would invest in and create bubbles followed by panic when the bubbles burst.

One of the symptoms of the Business, Sentiment cycle is Herd behavior. We discussed this earlier, but in the 1990s and early 2000’s, approximately $18 billion of new assets moved into domestic growth equities because of investor enthusiasm for the tech industry.

Three years before the peak levels, US large-cap growth stocks had returned 14% and had outperformed global equities by almost four percentage points per year. One of the mistakes investors made was another emotional mistake, called Representative Bias. This means that people have a tendency to predict future returns based on past and current returns. Many investors thought the high domestic growth technology industry returns, would continue for many years in the future. Shortly after, dot.com tech bubble burst, wiping out many portfolios. According to MorningStar reports in 2009, mutual funds with the greatest inflows tended to underperform those with the greatest outflows over the following three and five year periods.

With this all means is when investors perceive risk, they become risk-averse at the wrong time and lower their equity positions decreasing their chances for long-term wealth. Greg Fisher, chief investment officer for Gerstein-Fisher once said, “We don’t have people with investment problems, we have investments with people problems.”

Rebalancing your investments Another mistake emotional investors make, is failing to rebalance their portfolios. It’s important to weight a portfolio depending on your age, investment goals, and risk. This means that as an investment gains value, it commands a greater proportion of money, or weight, in your portfolio. When this happens, your portfolio becomes out of balance, causing your overall investment basket to become overly sensitive to market fluctuation.

“We don’t have people with investment problems, we have investments with people problems.”

We discussed Prospect Theory earlier. This is when you sell good investments and keep the bad. But rebalancing means your portfolio needs to maintain balance between stocks, bonds, treasuries, and other asset classes. And within the stock portion of your portfolio, a balance needs to be maintained between growth, value, small-cap, large-cap, and other sectors. If you are managing your investments on your own, rebalancing should be done every three months.

We also discussed Status Quo Bias. With respect to rebalancing, there’s a tendency to set and forget. Status Quo Bias causes you to avoid change. Rebalancing by definition is change. But you need change to make sure your portfolio does not become too volatile. This is one more reason why investing on your own may not be a good idea. The discipline and emotional detachment required is too much for most individual investors.

In 2006, before the Great Recession, I was invested nearly 90% in equities. I had a balance between Large-Cap, Small-Cap, Value, and Growth. The S&P decreased by 45%, and my losses completely mirrored the market except for the 10% of my portfolio held in cash. I was 54 years old, and should have kept at least 50% of my investments fixed or in asset classes that could not go down, like annuities. In January 2009, at exactly the wrong time, I put 10% of my portfolio into annuities. About three years late. This is just one more example of how, even those of us who think we know what we are doing, make serious mistakes.

I’ve also talked about Home Bias, your tendency to invest in what you know the best and are closest to.

For example, someone who works at a Wall Street stock brokerage will likely overweight equities. Someone who works at a real estate company will be tempted to put too much money in real estate. One GM retiree put nearly 80% of his investments in GM right before its bankruptcy. You will be very tempted to overweight investments that you are loyal to. But it’s critical that you balance your portfolio appropriately.

The Cost of Income

Another mistake in your portfolio is trying to get income from asset classes like annuities. For example, a company may offer 6% income on your investment.

But that 6% may come at a high cost. Often your quest for income may cost you an extra 1% fee. Find out how much an income rider will cost. It may be better to take income from selling equities or buying bonds. But even then, high yield bonds are closely correlated with preferred stocks. This means, as the stock market becomes volatile, bonds will react in the same way. It could be better to sell equities for income in part of your portfolio than to buy an investment that throws off monthly income.

The Impact of Inflation

Inflation is another risk that most investors ignore.

Historically inflation has been between 2.5% and 4%.

In fact the government will adjust Social Security payments based on the government produced statistic called the cost-of-living index. But if you have gone to a grocery store to buy milk, meat, or even produce, or pretty much anything you need not measured by the cost of living index, you know the government inflation rate is dramatically underestimated.

Inflation is very bad for your retirement. A retirement account with $100,000 today may be worth only $50,000 in buying power in 10 years. When I was in business school getting my MBA, we were expected to calculate net present value of investments calculating the value today of an investment versus 10 years in the future. But a simpler explanation is a movie I watched a few nights ago shot in 1984. The actor walked into a pizza store and ordered a pepperoni pizza for $3.50.

The last time I looked at pizza online, it was $12 with only one topping. Over 30 years from 1984 to 2014 the price of pizza in a very unscientific example quadrupled. The same thing will happen to your retirement portfolio. Make sure that any plans you make also have an inflation calculation for buying power over the next 10 to 30 years. The last thing you want is to have only enough money for rent and food but nothing else.

It’s also very interesting to see bank advertisements for CDs. From 2009 until 2014, rates were advertised at less than 2%. If you wanted to tie your money up for five years, you might be able to get 2.5%. But inflation is historically much higher. And real inflation for the things you buy is between 5% and 10%. Yet most people are financially illiterate. They think the only safe investment is money in a bank. While this is true for only $100,000, with an FDIC government increase slightly later, you are actually losing money after inflation. Any money past the FDIC guarantee is at risk. A bank CD is only a slightly better investment than keeping your money in a mattress. At least in a bank, your money is better protected.

This is particularly bad for seniors with fixed incomes.

There’s a natural tendency to keep your money safe when retired. Yet, if you don’t make the right inflation considered, retirement financial decisions, you will lose money every month.

The Impact of Taxes

Another big mistake investors make is not recognizing the cost of taxes in their portfolio. Even 85% of your social security can be taxed if you make more than $40,000 per year per 2014 rules. This is totally unfair since you already paid into the Social Security system during your work years. But the government can change taxes on your retirement anytime they want.

The latest ideas floated are means testing Social Security.

If you make more than $100,000 a year, or have more than $1 million in retirement assets, the government may take Social Security away from you completely.

The system currently is projected to run out of money by 2033 unless they make dramatic changes.

Those changes may mean that your payments are severely decreased or that you could be excluded from Social Security completely.

Another tax consideration is investment returns.

You should focus more on after-tax investment return and then on stated returns. Capital Gains tax is a moving object. Depending on who is in power running the government, it may move from 15% to as high as 35%, and change at any time. You already know that income tax is progressive. For example, making even $1,000 more per year can put you into a higher tax bracket. This may even cause you to reject a job promotion.

But the same is true with your investments.

In one study, it was shown that effective tax planning can add up to 1% higher return on your investments.

So whether you are working with a financial advisor, or on your own, look at returns on an after-tax basis.

One formula that nearly every financial advisor uses is the rule of 72. This is a measurement that considers compounding when calculating investment return. Albert Einstein once said that compounding is one of the wonders of the universe. Compounding starts with say, 10% return on $10, which gives you a one dollar return over the next year. But a 10% return on the following year would not be based on your $10 investment, it is based on the total return plus original investment of $11, times another 10% equaling $12.21 and so on for every year that you get a 10% return.

The Rule of 72

So would you like to learn how long it takes to double your money due to compounding? The Rule of 72 will show you how. Just take 72 divided by the interest percentage per year to find out the approximate number of years it will take to double your investment. For example, if you get an interest rate of 6%, it will take 12 years to double your money. But an interest or investment return rate of 12% annually will take only six years to double your money, because of compounding.

This is a really useful tool in estimating how much money you will have over 10, 20 and even 30 years, as long as you can estimate your investment rate of return.

A rule of thumb is to use a return of 7.25 for the stock market. In the last 60 years the US stock market has returned about 7.25%. So a realistic example is a portfolio of $100,000 invested in the stock market.

The Rule of 72 states that your investment would grow to $200,000 in just short of 10 year...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Contents
• Introduction
• One: Mental Accounting
• Two: Fungibility
• Three: Status Quo Bias
• Four: Endowment Effect
• Five: Foot in the Door
• Six: Loss Aversion
• Seven: Number Numbness
• Eight: Sunk Cost Fallacy
• Nine: Judgment Heuristic
• Ten: Extremeness Aversion
• Eleven: Prospect Theory
• Twelve: Arbitrary Coherence
• Thirteen: Anchoring
• Fourteen: Recency Bias
• Fifteen: Overweight Memorable Events
• Sixteen: Deadline Bias
• Seventeen: Overconfidence Bias
• Eighteen: American Expressaphobia
• Nineteen: Default Decision Making
• Twenty: Contrast Bias
• Twenty-One: Hyperbolic Discounting
• Twenty-Two: Home Bias
• Twenty-Three: How Men & Women Talk About Money
• Twenty-Four: Confirmation Bias
• Twenty-Five: Neuro-Economics
• Twenty-Six: Optimism Bias
• Twenty-Seven: Disposition Effect
• Twenty-Eight: Benefectance
• Twenty-Nine: Projection Bias
• Thirty: Framing
• Thirty-One: Bandwagon Effect
• Thirty-Two: Instant Gratification
• Thirty-Three: Procrastination
• Thirty-Four: Decision Paralysis
• Thirty-Five: Reversion To The Mean
• Thirty-Six: Snakebite Bias
• Thirty-Seven: Cognitive Dissonance
• Thirty-Eight: How Do I Turn Bias into Profit?