I'm irrational - let's get that out in the open. I'm overly optimistic, I frame decisions too narrowly, and I take mental shortcuts that lead me to wrong decisions. I make these and dozens of other mental mistakes because all human beings do. You may think that a good financial planner is safe from the usual errors identified by behavioral finance studies.
Guess what? Financial planners may think so, too - and overconfidence is one of the most common of those mistakes. Here are five questions to help you evaluate your evolution toward a purely logical mind.
#1: THE COIN FLIP
Which of the following two series of coin flips is more likely to occur?
A. Series 1 B. Series 2 C. Same
The answer is C. They are equally probable - the chance is 1 in 32. We tend to think of the first series as unusual because it appears to be a pattern. The second seems more random.
When we notice a pattern, we tend to bet that it will continue. For example, U.S. stocks closed 2007 with a fifth straight year of gains. Many of us predicted 2008 was going to be another gangbuster year and bought more than the usual percentage of stocks for our clients. Okay, that was an easy one. Let's up the ante.
#2: THE GIFT
Your client has been given $10,000, which she uses to buy 100 shares of each of two companies, ABC and XYZ, both trading at $50 per share. About a month later, ABC stock rises to $75 a share and XYZ stock declines to $25. Her total investment is still worth $10,000. If she has to sell shares in one of the two stocks, what would you advise her to do?
A. Sell ABC at $75 a share.
B. Sell XYZ at $25 a share.
The correct answer is B. That's because taxes matter. She was given the money, so it's in a taxable account, and she held it for only about a month, so the short-term gain would be taxable as ordinary income.
The math is simple here - if she sells the winner, she will have a $2,500 taxable gain and, at the 30% marginal tax rate, will have to pay $750 in taxes. If she sells the loser, however, her $2,500 loss actually gets her $750 back when she files her taxes.
Economically speaking, this is an easy choice. But if you missed this one, don't feel bad.
Roughly 75% of CPAs whom I teach miss it as well. That's because we've mentally tagged each stock to the $50 purchase price - a process called anchoring.
We have a tendency to try to lock in the gain forever by selling the winner, and believing the $25 stock is still worth the $50 purchase price. We believe if we sell the loser, we are permanently admitting that we made a costly mistake.
The $1,500 difference in taxes may be worth the psychological benefit we get from locking in the winner versus the pain from locking in the loser. But that's an emotional decision that will take money from her wallet.
Often, an emotional choice is rationalized by saying, "It depends why the one stock dropped." In reality, the chances are high that the market is right and the $25 stock is worth $25.
#3 : PICK A NUMBER
You are one of 30 logical students in a classroom. The professor asks all the students to pick a number between 0 and 100 that they think will equal 80% of the average number chosen by the entire class. The professor explains by telling students that if they think the class average will be 50, they should pick 40 (50 x 80%). Which number is closest to the one you chose?
A. 72 B. 40 C. 15 D. 5 E. 0
The correct answer is zero - choice E. Many students would have taken the teacher's example of guessing 40 to the next step, lowering it by another 20% and guessing 32 (40 x 80%).
But each student would likely realize eventually that every other student would also have figured it out, so they would reduce that 32 by another 20%. This would continue to occur until each student arrived at the logical conclusion that every student would pick 0.
If you picked a higher number, you may be showing a bit of overconfidence, and overconfidence is a particularly costly mindset in investing. Remember that successful investing means staying a step ahead of the masses by figuring out what other investors are thinking and then exploiting those thoughts before they do.
I witness overconfidence daily. A typical example is when market analysts say they are investing in emerging markets like Brazil, China and India because those economies are growing fast. Unfortunately, virtually every investor on the planet is also aware of this and that insight is, of course, already priced into those stock markets.
#4: SIMPLE COUNTING
Take 30 seconds to do a very simple exercise: Count the number of F's in the following sentence: Finished files are the result of years of scientific study combined with the experience of years. How many F's did you count?
A. 3 B. 4 C. 5 D. 6
The correct answer is six - choice D. There are six F's. Few people, including me, get this right when they first see the sentence.
That's because our brains take mental shortcuts known as heuristic biases. In this case, our brains might skip over the word "of" entirely, or see a v instead of an f in "of."
When it comes to investing, we take many mental shortcuts, as well. We assume, for example, that we have to be right only half of the time when it comes to timing the market. "Half" just seems to make sense. In reality, we have to be right far more than half of the time just to break even. As many investors have learned through painful experience, a 50% gain followed by a 50% loss results in a 25% loss.
#5 : FINDING PATTERNS
Look at the diagram below and write down the different patterns you see. You may see a hemisphere, quadrant, row or column that tends to have more cells with either XXX or blanks. How many patterns do you see?
A. 0 B. 2 C. 4 D. 6 E. 8
Did you notice the southeast quadrant is all X's, or that column D is as well? Did you see that the right half has more X's than the left, or that the lower left quadrant has the fewest X's? I, too, can find many clusters, yet these aren't patterns.
The correct answer is zero - choice A, although some readers may object to this answer. This diagram was made by me using a random number generator in Excel that gave each cell a 50% probability of containing an X.
The reason that you see patterns is that humans cannot think randomly. If you don't believe me, try randomly writing down "heads" or "tails" 25 times.
You'll find yourself recognizing a pattern and then changing to avoid that pattern, only to follow another pattern. In investing , it's hard to resist finding existing patterns in randomness.
We often see investing patterns based on the presidential election or the winner of the Super Bowl, or concepts like the Dogs of the Dow Or Stay Away in the May. According to Nerds on Wall Street author David Lein weber, the production of butter in Bangladesh correlated more closely to the S& P 500 between 1983 and 1993 than any other factor investigated.Unfortunately, Bangladeshi butter production isn't useful for seeing the future or making wise investment choices.
REAL MEANING OF THE QUIZ
You may be about ready to send FP's editors a note telling them the quiz is foolish. Before you do,understand that my goal is to push you to question how your mind is working.
Is your logical, reflective brain making risk-adjusted decisions to maximize your client's economic gain?Or perhaps ,like mine,your emotional, reflexive brain is in the driver's seat more than you would like to admit.
As planners,our job is to work closely with our clients to help them achieve their financial goals.To do this, we have to be aware of their biases-and our own.
Allan Roth, founder of the planning firm Wealth Logic in Colorado Springs,Colo; writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at Colorado College and the University of Denver.