Logical Thinking and Behavioral Finance SRI in the Rockies October 19, 2002 Johann A. Klaassen, Ph.D

Logical Thinking andLogical Thinking andBehavioral FinanceBehavioral Finance

SRI in the RockiesOctober 19, 2002

Johann A. Klaassen, Ph.D.

Logical Thinking and Behavioral Logical Thinking and Behavioral FinanceFinance

Classical economic theories presume that the individual human being is fully informed and ideally rational when making economic decisions — and strong-willed enough to follow through, even on tough decisions. But recent developments in “behavioral finance” question this view …


The Three Biggest Money

Mistakes We Make — and Why We

Make Them

Critical Thinking and the Financial

Professional; or, How to Do

Things with Words

Money Mistake #1: Living in Money Mistake #1: Living in the Pastthe Past

Despite all our warnings, our clients insist on taking past performance as an indicator of future results.

This leads them to buy at or near highs, and sell at or near lows.


DALBAR: From 1984 through 2000, the S&P averaged 16.29% gains — but equity mutual fund investors averaged only 5.32%.

Why do we do this?


Human brains are tremendous trend-spotters — it only takes two or three repetitions to pick up on a simple pattern.

After hearing about three years of astonishing performance, for example, we feel confident predicting future good performance.


BUT: Our brains require about six repetitions to see a repeating, cyclical pattern — so we’re more likely to explain away a drop than to see it as a part of a cyclical pattern.


Thinking Critically:This is an example of the fallacy of “hasty generalization”: we jump too quickly from recent, short-term results to a prediction of future results.


Q: How can we help our clients to not buy the hot stuff (or understand why we’re not doing it for them)?A: Raise two ideas: “mean regression” and “time horizon”.


Mean Regression and Time Horizon

-35

-30

-25

-20

-15

-10

-5

0

5

10

Sci-Tech Funds

Large Growth

Mid Growth

Small Growth

Money Mistake #2: Safety in Money Mistake #2: Safety in NumbersNumbers

Our clients often ask us to do what their neighbors’ advisors are doing – that is, they want to “follow the herd”.


When combined with MM#1, this leads to such silliness as March 2000, when 85% of all net fund inflows went into tech funds (Leuthold Group) – “I want to profit from tech, like everyone else!”

Why do we do this? Perhaps there’s a parallel with “Pascal’s Wager” (pardon the irreverence):


Pascal’s Wager Client’s Wager

Sin No Sin

Alone

With Herd

GodInfinite Pain

Infinite Joy

Wrong

Very Bad

Not So

Bad

No God Small

JoySmall Pain

Right

Very Good

Not So

Good


There’s little shame in being one of many people hit with a major loss, and there’s some (but not much) pride in being part of a big winning group.

“Regret aversion”: We really hate to have big regrets, and we know that to receive huge rewards we have to risk huge losses.


Thinking Critically:This is an example of the “appeal to the masses”, probably, with a hint of an “appeal to the consequences of belief”.


Q: How can we help our clients to not run with the herd?A: First, tell them to turn off CNBC, since the constant stream of information is more likely to confuse than to help; second, create a written Investment Policy Statement to document needs and strategies.

Money Mistake #3: Sunk CostsMoney Mistake #3: Sunk Costs

Consider this scenario:Say you have $10,000 of MSFT with a cost basis of $5,000, and $10,000 of IBM with a cost basis of $20,000. Now you need $10,000 for your child’s tuition payment — what do you sell?


How many times has a potential client said “As much as we’d love to work with you, we can’t change anything about our investments right now – we’ve lost so much, we just can’t make any real changes until the market has come back a little”?


How many investors (and advisors) watched investments in Enron, WorldCom, Kmart, and all the others, slip away – unable to push the big green button and sell because of the pain “losing all that money” would cause?


Gary Belsky & Thomas Gilovich:We spend more money on car repairs because we’ve already spent so much on the car; we keep spending money on tennis lessons because we’ve already spent so much. We hold onto bad investments because we can’t get over how much we paid for them and can’t bear to make that bad investment ‘final.’


Thinking Critically:This is probably not so much a fallacious way of thinking about our investments as it is a harmful way of NOT thinking about our investments. Perhaps we could call this kind of financial superstition a variety of “wishful thinking”.


Q: How can we help our clients to let go of sunk costs?A: First, ask them to ignore their past for a moment – “if you had this $1000 in cash, instead of these shares that cost you $10,000, would you buy today?” Second, establish a written selling discipline.


One of the key reasons that clients seek our advice in the first place is the simple fact that they recognize a need to have some “objective observer” involved in the process. If we succumb to the very errors they’re hoping we’ll help them avoid, what is our value to them?


How can we most effectively help our clients to avoid making these and other errors? Perhaps a class in human psychology or critical thinking at our local community college would be worthwhile. Short of that …


Here are three books likely to help:David C. Wilson, A Guide to Good

Reasoning (McGraw-Hill)Stephen S. Carey, The Uses and Abuses

of Argument (Mayfield)Wanda Teays, Second Thoughts: Critical

Thinking from a Multicultural Perspective (Mayfield)


And I’m available for consultations, too:

(800) 422-7284, x [email protected]


Questions?

Documents

Logical Thinking and Behavioral Finance SRI in the Rockies October 19, 2002 Johann A. Klaassen, Ph.D