When I tell clients that pain is a strong indicator of good investing, they usually laugh. I admit it sounds like a punch line, but it also happens to be true, and my theory is backed by some strong academic research.
Further, I tell clients that, if a potential investing move feels right, that’s a strong indicator to hold off. Sounds weird? Let’s delve into the human mind, and then I’ll apply that understanding to investing.
HOW HUMANS THINK
In the real world, risk correlates with reward. It’s unusual that someone gets a large reward without taking a huge risk. Successful entrepreneurs have taken large, but smart, risks, with some reaping rewards in billions of dollars. Our minds, though, are often disconnected from reality, and we view risk and reward as disconnects.
Experiments published in 1994 by Ali Siddiq Alhakami and Paul Slovic revealed that people base their judgments of an activity or a technology not only on what they think about it, but also on how they feel about it.
If their feelings toward an activity are favorable, they are moved toward judging the risks as low and the benefits as high; if their feelings toward it are unfavorable, they tend to judge the opposite — high risk, low benefit. Of course, the pattern isn’t logical, but it’s how humans think. Slovic called this the affect heuristic.
RISK AS FEELINGS
In 2001, researchers led by George Lowenstein of Carnegie Mellon University proposed a new model in a paper entitled “Risk as Feelings.”
Our cognitive evaluation is not as logical as we might think it is, because our thinking is affected by subjective probabilities and emotions. Yet feelings drive our behaviors, as well.
In his 2011 book, Thinking, Fast and Slow, Nobel Economics Prize winner Daniel Kahneman discussed our two ways of thinking:
System 1: Rapidly, automaticly, frequently, emotionally, stereotypically, subconsciously.
System 2: Slowly, effortfully, infrequently, logically, calculatingly, consciously.
Essentially, system one is rooted in how we feel, while system two is, supposedly, rooted in logic. Two critical points, however, are that both systems reflect how we think, and that we typically don’t know which system we are thinking with. We assume we are always using logic when making decisions.
PLEASURE-PAIN VS. RISK-REWARD
We can examine the use of our two thought systems in investing matters using the returns on a broad, total stock market index fund.
System 1 feels more pleasure and pain. It views the stock market as high reward and low risk at the height of bubbles, and high risk and low reward at the bottom.
System 2 always considers stock investing to be risky, but leads to the conclusion that stocks are a better buy after a half-off sale than after the price has doubled. Our thoughts also assess the high probability that capitalism will survive. When stock prices reach an all-time high, System 2 knows there is a low probability that stocks will rise indefinitely without the arrival of a bear market.
Research indicates that System 1 typically prevails in investing. Most data show investor returns typically lag fund returns due to poor market timing. Fund flow data reveal we buy more stock funds near the top price and sell more near the bottom.
Buying stocks in 2008 and early 2009 meant we had to overcome System 1 thinking and buy more of what caused us so much pain. Lowenstein’s model explains the vividness — or sharp decline — of the second market plunge.
Despite my knowledge of behavioral finance, the stock buys were the hardest I’ve ever made for my own portfolio. Financial theorist William Bernstein described my feelings perfectly when he told me the best financial moves he has made typically occurred when he wanted to throw up.
It’s easy to see how System 2 is superior in hindsight. In the midst of whatever emotion has us in its grasp, it’s not so easy to distinguish which system we are accessing, because System 1 tricks us into thinking we are being very logical.
Behavioral finance readily explains how we can think we are being logical while doing illogical things such as:
Recency bias: When stocks plunge, we expect the drop to continue. When stocks surge, we also extrapolate the recent past.
Data mining: We are pattern-seeking animals and will look for patterns that validate System 1 thinking.
Confirmation bias: After a plunge, System 1 tells us stocks have high risks and low rewards. We seek out support for this feeling, finding theories that we are about to enter another Great Depression and why cash is a safe haven.
Herding effect: We all like to believe we are contrarians. But research shows we are herd animals. Seeking safety, we often falsely believe the herd is led by experts. It hurts far less when we take a financial hit and our neighbors lose a similar amount than when we lose alone.
No matter how much we try to convince ourselves that our logical System 2 thought process is steering, these biases reveal System 1 thinking. The more narrowly we slice the market, the more System 1 thinking takes charge.
PAIN AS VALIDATION
Making better cognitive decisions involves working through the pain. That’s not to say that pain alone provides validation. But if we can get our clients to embrace the pain and then apply System 2 thinking, we’d provide sound service to them.
The first step is to recognize whether a client’s concerns are coming mostly from System 1 or System 2 thinking. If System 1 is in charge, then the clear solution is to slow down the thought process long enough to engage System 2. This is true whether the client is considering buying after a surge or selling after a plunge.
In late 2008 and early 2009, I told my clients it was natural to feel pain and that I empathized, since I was suffering myself. Having said that, I encouraged them to get System 2 going (not by name). I asked if they thought it was more logical to buy or sell stocks after a half-price sale.
I asked if they thought if capitalism was really dead. I had them reframe the way they thought about owning stocks as owning companies that made products or provided services we use daily.
The recent market drops are a bit scary. Wall Street Journal columnist Jason Zweig told me that advisors can’t promise their clients this isn’t the beginning of another 2008 crash or, for that matter, a 1929 crash.
His advice was to tell clients to avoid looking at the red arrows on stock index summaries and to read anything else.
Zweig also noted that it was quite possible the panicked client was someone who needed to be talked off the cliff in 2008 and 2009. He suggested planners use this time as an opportunity to fire clients. Keeping a client who rides the fear and greed cycle continuously is good for nobody.
I suggest telling clients to embrace the pain and take it as a good sign. There are no guarantees. But the odds are they will be glad they worked through the hurt.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.
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