Investment Thoughts From A Nobel Prize Winner
Would it surprise you to know that the 2002 Nobel Prize for economics was won by a – psychologist?
The prize was for his work in behavioral finance. This guy must be good, right?
So let’s spend a little time this week looking at what Daniel Kahneman has to say about what causes investors to make mistakes.
‘In standard economics and standard financial analysis,’ he says, ‘people are assumed to be rational. That means they have a consistent system of beliefs and they act on those beliefs and they have consistent preferences.’ Sounds logical, right? Wouldn’t we all like to think we are like that?
Then he says we have to ‘Give up the assumption that people are assumed to be rational when it comes to finance. When you abandon the assumption of rationality you have behavioral finance’ in the broader field of behavioral economics.
If you could change one thing about your investment behavior that would improve your fiancés – what would it be? It would probably be different depending on your financial situation. You can become really successful by make simple changes gradually. It’s probably the opposite of “New Year’s resolution” thinking. That all or nothing kind of resolute behavior that never lasts long. In order to get ahead you need to step outside your situation and look at it with a sense of detachment. What advice would you give someone like yourself? Diversify? Get a proper plan in place and then stop watching investments and the market? Use some common sense? Stop using debt? Write things down. The cold hard facts in writing are hard to dispute. Write down you total assets net of loans. Do you have an estate greater than 1.5 million or less than that with lots of IRA money? You’ve got a problem. Do you have a minus estate after debts are paid off? You’ve got a problem. Figure the steps you should take and write them down – then begin to take them one – by – one . . . . .
Narrow framing – another challenge to your finances discussed by nobel laureate Daniel Kahneman in a recent article.
So what is narrow framing. Sounds like a problem with replacement windows. Too much emphasis on being right in very narrow choices.
People will often end up doing the wrong thing when they make decisions in a vacuum. For example, looking at investment problems in isolation from the whole portfolio – this, according to Nobel Prize winner Daniel Kahneman, is the most common and fundamental source of mistakes.
What is the bigger picture? How can you reframe your approach? Get help from someone who is knowledgeable and dispassionate about your investments.
Having someone who is dispassionate about the investments and who can see the big picture is “a big advantage in getting things right” Kahneman says.
He goes on to say “It is clear from research on individual investors that the great majority of them are out of their league. They are bound to lose money on average because they are hyperactive, they churn their accounts and they don’t even know how well they are doing. Many people think they are successful – they manage to delude themselves.”
What is an example of this? I hear it all the time. Investors say, this fund is not performing well. I lost money on it last year. Ever hear anyone say that? Ever say that yourself?
Looking at a fund – say it’s a small cap that didn’t do well – like in 1999. So you got out of it and put the money into your tech stocks that were zooming. What happened? Tech dropped like a rock and small caps were the heroes – and have been for several years now. You were casing returns. If your portfolio called for small caps as part of your diversification and you were following basic rebalancing, you would have bought more – and made your portfolio a lot more bullet-proof in the down years of 2000 - mid 2003.
Helping people make better decisions
Are you willing to take advice? Asking for advice on specific investments is the wrong path to take.
Did you ever hear a conversation at a party – or have you read the newspaper investment column lately? People want advice on a specific problem investment. Most financial writers and advisors will give it to them. “People need to be educated to ask advice about the big picture,” Nobel Laureate Daniel Kahneman says – “and always to consider decisions in the context of their overall situation and objectives.”
Sounds logical, doesn’t it? So why don’t people do it? Is it the same reason we are sometimes penny wise and pound foolish? We focus on the trees and not the forest? The detail instead of the bigger picture and bigger goal?
I’ve seen studies that talk about personality styles. Do personality styles have anything to do with investing? Sure they do. Some styles are task oriented and some are big picture. Too much of either one can get you into trouble. Are you good at seeing the whole picture – visualizing where you want to go, setting goals and such? Are you good at taking steps to get somewhere? If someone tells you what the objective is, you can plan the steps to take them there. Few people are good at both – if you are you are very unusual.
I’ve gotten to a stage in my life where I willingly admit I am great with ideas, concepts and strategies bad with detail - and I need a counterpart who can see the detail. Maybe your spouse is like that? In my practice I always try to hire people with the skill I don’t have.
Behavioral finance. Understanding it and ourselves can help keep us from making common investment mistakes.
Do you think Warren Buffet makes investment mistakes? Back in 2002 when it seemed no one was making money in stock his company returned a 400% profit.
Buffett learned some lessons as a young man and studied the writings of two economic thinkers of the day to arrive at his wining ability to make good investment decisions. Of course, at this stage of things he is buying whole companies – but it wasn’t like that back in the beginning when he stared out with $100 to invest.
What’s the difference between you and Warren Buffett – other than a few billion dollars, I mean. Did he start off doing anything you couldn’t do? I don’t think so.
I seem to remember reading in one of Tom Stanley’s book – probably the Millionaire Mind – that the most successful business people were often not the most book-smart kinds in school. By accepting that they had some limitations, they were able to focus on what they did well. Often what that was, was making money. I don’t now about you, but sometimes I think too much. I can come up with a dozen great ideas – and not do any of them – when just one idea would do.
So I’ve had to develop ways to cope with my shortfall. My preferred method is to adopt a system from someone who is successful rather than try to invent one myself. I have some great systems that save my bacon when I start to get too creative – and think too much. I like to think and plan. Now I try to keep it more recreational. I know when I’m thinking too much or I have too many ideas.
As I’ve mentioned before, putting things on automatic pilot works for me. What works for you?
“People should be educated to ask for advice about the big picture.” That’s advice from a Nobel Prize winner in economics.
Daniel Kahneman, Noble winner in 2002 was interviewed recently about individual investors and how they can do better. Are you aware that the majority of investors don’t make the market averages in their portfolios? It’s not because they have poor investment choices – although that does cause a lesser return. Even with great choices – you have to stay in them – even when it doesn’t feel good – to get ahead. In fact, buying the lowest performing market segment at the end of each year – also called rebalancing – is so profitable it’s hard to believe so few people do it!
Market timing does not work. Selling because you are afraid of prolonged market drops is a big loser for individual investors. Selling what you have and buying what did well last year – is the opposite of good financial strategy.
After saying that people should be educated to ask about the big picture, Kahneman went on to say “and always consider particular decisions in the context of their overall situation.”
I love do-it-yourselfers. Sometimes I am one. They do their own taxes, perhaps their own legal work – you can buy a will kit, you know – and their own financial advising. Who is doing the big picture work here? Or maybe she has an accountant and lawyer and financial advisors but they don’t ever get together and plan together for her. So he makes tax decisions in a vacuum and financial decisions without considering the taxes and investment decisions without considering the college financial aid he’ll lose and gifting decisions without considering the horrendous legal and tax problems they will cause – often after he is dead and gone.
Maybe we should all read Dan Kahneman’s writings?