Logical

Logical Thinking
Thinking and
and
Behavioral
Behavioral Finance
Finance
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 …
 Logical Thinking and
Behavioral Finance
• 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 the 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.
 Money Mistake #1:
Living in the Past
• 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.
 Money Mistake #1:
Living in the Past
• 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.
 Money Mistake #1:
Living in the Past
• 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.
 Money Mistake #1:
Living in the Past
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”.
 Money Mistake #1:
Living in the Past
Mean Regression and Time Horizon
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 Money Mistake #2:
Safety in Numbers
• Our clients often ask us to do what
their neighbors’ advisors are doing
– that is, they want to “follow the
herd”.
 Money Mistake #2:
Safety in Numbers
• 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):
 Money Mistake #2:
Safety in Numbers
Pascal’s Wager Client’s Wager

Sin No Sin Alone With

Herd
God Infinite Infinite Wrong Very Not So
Pain Joy
Bad Bad

No God Small Small Right Very Not So

Joy Pain
Good Good
 Money Mistake #2:
Safety in Numbers
• 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.
 Money Mistake #2:
Safety in Numbers
• Thinking Critically:
This is an example of the “appeal
to the masses”, probably, with a
hint of an “appeal to the
consequences of belief”.
 Money Mistake #2:
Safety in Numbers
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
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?
Money Mistake #3: Sunk
Costs
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”?
Money Mistake #3: Sunk
Costs
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?
Money Mistake #3: Sunk
Costs
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
Money Mistake #3: Sunk
Costs
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.
 Logical Thinking and
Behavioral Finance
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?
 Logical Thinking and
Behavioral Finance
• 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 …

• Courtesy First Affirmative Financial

Network LLC.