Posted by on Dec 11, 2016 in Articles & Advice, Blog, Featured, Posts |

By Jason Zweig | Dec. 10, 2016 1:07 pm ET

Image credit: Frederick Edwin Church, “Niagara” (1857), National Gallery of Art


I’m pretty sure this piece — published in 1997 — was the first article I ever wrote about behavioral finance. I’ve learned a lot in the past two decades, and researchers have also discovered more about how people make financial decisions. I would write it quite differently today. But two decades later, the basic principles seem to be holding up pretty well.  And, with stocks hitting record highs this month, there’s no better time to think about how you would behave if they take a record drop instead.

When the Stock Market Plunges…Will You Be Brave or Will You Cave?

By Jason Zweig with Malcolm Fitch

Money Magazine, Jan. 1997

If ever there was a likely candidate to load up on aggressive growth funds, it’s Bobbi Bensman. This 33-year-old resident of Rifle, Colo. is one of America’s premier female rock climbers. Bensman gets her kicks out of clinging to the cold face of a cliff hundreds of feet off the ground. In 1992, she fell 50 feet off a rock face in Colorado, escaping serious injury only because her rope pulled taut, breaking her fall, at the exact moment she hit the ground. “I have eight lives more,” shrugs Bensman. “Climbing isn’t really that risky as long as you know what you’re doing.”

But investing? Now that, says Bensman, is risky: “When it comes to mutual funds, I stay away from the really aggressive ones — they’re nuts. About all I can handle is Fidelity Equity Income” — a stolid portfolio that Morningstar rates half as risky as the typical stock fund.

Bobbi Bensman’s attitude toward risk defies the usual expectations — and that’s why she’s not an unusual investor at all. When it comes to weighing risk, most of us, like Bensman, are a tangle of internal contradictions, caught somewhere in the spidery web spun by fear and greed.

In fact, if I could give you only one piece of financial advice, it would be this: Spend less time studying your investments and more time studying yourself. That’s because how much money you make in an investment often depends far more on how you behave than on how it does. “It’s people that lose money,” says Patrick Chitwood, an investment adviser in Birmingham with a Ph.D. in psychology. “It’s not investments.”

To see what I mean, look at PBHG Growth Fund. In the second half of 1990, when the U.S. stock market slipped 6%, this small-stock fund skidded 21%. Over the next two years, investors yanked out nearly all their money, shriveling PBHG’s assets from $12.5 million to $3.5 million. Bad move: From the end of 1990 through 1995, PBHG Growth’s 35.1% annual return transformed a $5,000 investment into $22,503. Someone who fled PBHG and earned the overall market average of 16.6% annually would have turned $5,000 into just $10,776 — less than half what PBHG produced.

That huge $11,727 difference is the price of poor self-knowledge. Chances are, most of the people who bailed out of PBHG had honestly believed they were long-term investors who could stomach the fund’s high risks. They were wrong.

That’s partly because it’s harder than ever to know how much risk is too much for you. Except for the two short, sharp shocks of 1987 and 1990, the broader U.S. stock market has been going almost straight up for nearly 15 years. Our last prolonged bear market ended when Gerald Ford was President, in December 1974, after the Dow Jones industrial average fell 45.1% in 23 months. Today, after such a long stretch of success, the risk of losing money seems almost farfetched.

As it happens, most people have very similar misperceptions of risk, which you can learn to avoid. Over decades of research, psychologists like Princeton’s Daniel Kahneman and his late colleague, Amos Tversky of Stanford — along with economists led by Richard Thaler at the University of Chicago — have mapped these misperceptions. First, we’ll look at some of their findings. Then we’ll explore how you can use them to become a smarter investor.

Do You Have Jaws Syndrome?

In 1975, Steven Spielberg’s movie about a killer shark hit the theaters, and suddenly Americans were terrified of going into the ocean — even though there had been a grand total of only 66 shark attacks in U.S. waters over the preceding 10 years.

“We tend to judge the probability of an event by the ease with which we can call it to mind,” explains Kahneman. But that’s a bad way to assess risk; an event does not become more likely to recur just because it is recent or memorable. In 1975, for instance, the odds of being attacked by a shark in U.S. waters were about one in 300,000,000 — and, since sharks don’t go to the movies, the odds certainly didn’t worsen after the film was released. But because Jaws was so vivid and fresh in people’s minds, it drowned out all the statistical proof that beaches were safe.

Similarly, after the October 1987 stock market crash, panicked investors virtually stopped buying stock mutual funds for the next year and a half. Instead, investors snapped up bonds and cash — despite the overwhelming historical evidence that stocks had outperformed them both over the long run.

Do You Think All Risks Are Equal?

Which would you choose: a sure gain of $800, or a gamble that has an 85% chance of paying $1,000 and a 15% chance of paying you nothing?

Next, would you choose a sure loss of $800, or a gamble with an 85% chance you will lose $1,000 and a 15% chance you will lose nothing?

If you’re like the vast majority of people, in the first example you would take the sure gain — even though, on average, the payoff from the gamble will be $850, or $50 more than the sure thing. But in the second example, more than seven out of 10 people will take the gamble instead of the sure loss — even though, on average, this gamble will leave you $50 poorer.

The clear conclusion: Most people would rather take a risk to avoid a certain loss, but they would rather take a sure gain than gamble for more. “The typical person,” explains Kahneman, “experiences the pain from losses about twice as keenly as he feels the pleasure from gains.”

When Do You Kick Yourself Hardest?

During the past year, Paul was tempted to switch from stock A into stock B when both traded at the same price, but he stayed put. George, meanwhile, started out owning stock B but switched to stock A. At the end of the year, stock A was worth $1,200 less than stock B. Who feels worse about his decision?

Research shows that most people answer that George would feel worse than Paul. Why? A mistake that results from action tends to be more painful than one that results from inaction. “What investors fear even more than losing money,” says Richard Thaler of the University of Chicago, “is having to say, ‘What an idiot I am.'”

This fear of regret leads to what Harvard economics professor Richard Zeckhauser calls “status quo bias.” One of the most common responses to risk is to let inertia take over; instead of making a new decision, we abide by the last one and hope for the best. That’s why, when the market crashes, it’s so hard for people to do the right thing and buy more stock; investors instinctively fear that taking any new action might make them feel even worse if the outcome is bad.

Then there’s the “near miss.” Say the winning number in a lottery was 865304. John picked 361204; Mary picked 965304; Peter picked 865305. Which of them is the most upset? Most people agree that Peter feels the worst, because he came “closest” (even though all losing numbers are equally incorrect). As Kahneman explains, “People become more frustrated in a situation where a more desirable alternative is easy to imagine.”

For example, even though the odds of winning a lottery are absurdly low, someone almost always wins — making those who do not play regret not having had a chance. Economic consultant Peter L. Bernstein, author of the superb new book Against the Gods: The Remarkable Story of Risk, thinks this helps explain why relatively few investors buy index funds, which match the market’s return but eliminate any chance of beating it. Many investors would rather try to find a possible big winner than settle for a fund that’s only “average.” (Never mind that in the long run only about one out of six stock funds has managed to beat Standard & Poor’s 500 index.)

Do You Know How Much You Know?

A group of people was asked which is longer, the Panama Canal or the Suez Canal, and then asked how certain they were that their answer was correct. Among those who were 60% certain, 50% of them got the answer right — meaning that this group was 10% too sure. But among those who were 90% certain, only 65% got the answer right, meaning that this group was 25% too sure.

The more convinced we are of our knowledge, the bigger the gap is likely to be between what we actually know and what we think we do. Such overconfidence leads us to inflate the value of our own skill, leading to what psychologists call the illusion of control. Years ago, when a Spanish national lottery winner was asked how he selected the ticket number, he answered that he was positive his lucky number ended with 48 — because, he said, “I dreamed of the number seven for seven straight nights. And seven times seven is 48.”

No wonder Kahneman says that “When people take risks, it’s often because they don’t understand the odds. One of the hardest challenges is to know just how little you really know.” If you overestimate your skills and knowledge, you may be unrealistically optimistic about your investment prospects. That will worsen your shock when the market tumbles, increasing the odds that you will panic and bail out at the bottom.

How Secure Is Your Anchor?

One group of people is asked to assess the probability that the population of Turkey is more than 5 million; another is asked the likelihood that Turkey’s population is less than 65 million. Then both groups are asked for their best guess of Turkey’s population. The first group guesses 17 million; the second, 35 million. (The correct answer: roughly 63 million.)

By anchoring our judgments in handy impressions like the hints we get in a series of numbers, we become more comfortable with our decisions. But as the Turkey example shows, if the anchor — in this case, the “more than” or “less than” figure — shifts, our decision will move with it.

Thus investors often anchor their view of a stock’s current value on its historical prices. Back in 1992, the stock of U.S. Surgical Corp., which in just one year had shot up fourfold to $131.50, looked suddenly cheap when it fell to $56.50. Even people who thought $56.50 was too high a price “on the way up” were tempted to take another look at the stock once it fell so far back; when the anchor shifted, their opinions swayed with it. But new competition was hurting U.S. Surgical — and, after a rally up to $76.50, the stock resumed falling until it dropped to $16 in early 1994. The lesson: A bad anchor can pull you under.

Which Wallet Do You Use?

Imagine you paid $40 for a ticket to see a play. As you approach the theater, you realize you’ve lost the ticket. You still have plenty of cash. Would you pay $40 for another ticket?

Now say you want to buy a $40 ticket for a play. Approaching the theater, you see that you’ve lost $40. You still have plenty of cash. Would you buy a ticket?

Oddly, surveys have found that only about 50% of people answer yes in the first example–but more than 80% answer yes in the second. Why? Richard Thaler, the University of Chicago economist, concludes that people separate their money into different “mental accounts.” In the first example, to replace the lost ticket, you need to withdraw cash from a mental wallet already earmarked for tickets — and that feels like spending twice for the same thing. In the second scenario, the $40 is missing from a mental account labeled “cash,” leaving the account for tickets unaffected. This time, buying a new ticket feels less redundant, even though you’ve lost $40 either way.

Now let’s put this concept into an investing context. Imagine that Bob earns a flat $55,000 salary while Roberta makes a $45,000 base salary and a $10,000 bonus. Thaler has found that Roberta will invest more than Bob; she is likely to put her bonus into an “investing” mental account, while the base salaries of both will go into a “spending” mental account.

When you place a stop-loss limit order on a stock, you are also using mental accounts. If you buy 100 shares of a stock at $30 and instruct your broker to sell it if it drops below $25, you have divided your $3,000 into two pieces: a $500 account you’re willing to gamble with and a $2,500 account you want to keep risk-free.

One big problem arising from mental accounting: People take the wrong risks in the wrong places. Nationwide, 16% of the assets in 401(k) plans are in guaranteed investment contracts, low-yielding fixed-income funds that are insured against capital loss. “That guarantees that you won’t lose any money,” says Thaler, “but it also guarantees that you will retire poor.”

So why do people take too little risk in retirement accounts like 401(k)s? Explains Thaler: “People think, ‘Retirement is my biggest goal, so that’s where I’d better be the most prudent.'” As a result, retirement funds, which should carry greater risk since they are funding a longer-term goal, often end up bearing less risk than regular taxable accounts.

Now that we’ve run through some of the problems of assessing risk, let’s see how you can fix them.

Remember That Risk Can Take Many Different Forms

Investment risk is not only the danger that your portfolio could lose value. There’s also the possibility that your assets will not grow faster than inflation. In reality, inflation is far more punishing than market crashes. Consider this: If inflation persists at an average rate of 3.5% for the next 25 years, it will shrivel the purchasing power of $1 to 42 cents. Cash will protect you against a market crash but not against inflation; for that you need equities.

Another kind of risk: Your cash requirements may rise faster than your portfolio. Explains Robert Jeffrey, an investment manager in Columbus, Ohio: “Remember that you need to think through the liability side of the equation too,” by estimating the size and timing of your future spending needs. “It’s your future need for cash that really should determine how much volatility you can tolerate,” says Jeffrey. If your likely cash outflows are large but far off in the future, you not only can but should take more risk today; if they’re coming up soon, then you should keep your risk low.

Jeffrey makes this suggestion: Imagine you lose your job for a year. How much cash would you really need to tide you over? That’s your worst-case scenario. Anything over that sum is money you can and should take risks with.

Lower Your Expectations

Be sure to use the longest available average returns to define your expectations for a particular stock, a mutual fund and even broad asset categories like stocks or bonds; short-term averages can be very misleading. And regardless of its recent performance, if you’re buying a stock fund, you should reckon on earning a long-term annual average of 6% to 10% pretax; that way you’ll be pleasantly surprised if you do better but not too shocked if you do worse. And don’t expect your fund manager to walk on water. If the market crashes, virtually every portfolio will lose money.

Don’t Count So Often

According to a recent study by the American Stock Exchange, 38% of young middle-class investors check their investment returns at least once a week, 17% check them monthly, 10% check yearly — and the rest “never” check. While never is not often enough, once a week is way too often. The more frequently you check on your investments, the more volatile they will look to you. My advice: Force yourself to check the value of your investments no more than once a month.

Don’t Let Cash Pile Up

“If you build up a lot of cash and have to make a decision about what to do with it all at once,” says Thaler, “that’s much scarier than moving the same amount of money in many smaller pieces.” Thus you should set a ceiling for your cash by saying something like this: Whenever my cash surpasses 25% (or any other level you set) of my total assets, I have to put that excess amount to work in stocks or bonds.

Tie Yourself to the Mast

If you make a habit of dollar-cost averaging into a particular mutual fund — investing a fixed amount at regular intervals — you’ll stand a better chance of sticking with it than if you’d thrown in a big chunk of money all at once. Think of Ulysses in Homer’s Odyssey, who resisted the deadly lure of the Sirens’ songs by having his crew “tie me hard…to hold me fast in position upright against the mast.”

Use Different Wallets

If you wanted to try casino gambling but were afraid you might lose too much, you might leave your wallet in the hotel safe and bring only a few $20 bills onto the gambling floor. Thus if you think you should take on a little more investment risk but are afraid to do so, you should set up separate mental accounts. If you must, leave the money you absolutely can’t lose where you feel it’s secure, but designate a small portion of your assets or your income as a risk-taking account. There’s no better place to do this than in a 401(k) or similar retirement plan, where your employer’s matching contributions give you an extra cushion.

Look at the Big Picture

“Ask yourself,” says Thaler, “how different your life would be if the market fell by 25% and stayed down for five years.” If you’re retired and you live off your investment portfolio, your life might be disastrously different. If not, life might not be much different financially — just painful psychologically.

It’s important to be honest with yourself: If you overestimate the pain a future market slide will cause you, you’ll end up investing more conservatively than you need to. But if you underestimate it, you’re almost certain to end up bailing out at the bottom.

To minimize your regret if the market falls, “don’t look at your investments one at a time,” advises Daniel Kahneman. “If you view them in isolation, you’ll have more decisions to make — and more opportunities to feel regret.”

Instead, use the stock portion of all the mental accounts in your portfolio to measure your risk dosage. Say you think you’re comfortable with a pretty high risk level, putting 80% of your portfolio in stocks and 20% in cash and bonds — but you’re honest enough to admit that a market crash might shake your conviction.

After settling on your 80% target, the best step is to put it in writing or tell your family about it. Then meet your target with a basket of stocks or a few mutual funds. If the market crashes and the stock portion of your portfolio falls below 80%, remember: You have made a commitment to buy just enough to get that ratio back up to 80%.

Let me leave you with these thoughts. Successful investors control the controllable. You can’t prevent the market from crashing someday, but you can control what you do about it. The more honestly you understand your own attitudes toward risk, the more likely you are to thrive no matter what the market throws at you.

Definitions of ANCHORING, BEHAVIORAL FINANCE, OVERCONFIDENCE, and RISK in The Devil’s Financial Dictionary
For further reading:
Daniel Kahneman, Thinking, Fast and Slow