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1) Rule #1 Don't lose money ...Avoid Mistakes  2) Rule #2 Don’t Forget Rule #1 The problem is you don't know what you don't know until you learn the hard way.

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Money blunders of the otherwise intelligent


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    money blunders of the otherwise intelligent

    MONEY BLUNDERS

    OF THE

    OTHERWISE

    INTELLIGENT

    MONEY BLUNDERS

    OF THE

    OTHERWISE

    INTELLIGENT

    COMMON WAYS

    SMART PEOPLE LOSE MONEY

    COMMON WAYS

    SMART PEOPLE LOSE MONEY

    Training ONLY not to be used with the

    public

    Training ONLY not to be used with the

    public

    two fundemental rules

    TWO FUNDEMENTAL RULES:

    1) RULE #1 DON'T LOSE MONEY ...AVOID

    MISTAKES

    2) RULE #2 DON’T FORGET RULE #1

    AVOID

    MISTAKES

    THE PROBLEM IS YOU DON'T KNOW WHAT YOU

    DON'T

    DON'T KNOW WHAT YOU

    DON'T KNOW UNTIL YOU LEARN THE HARD WAY.

    Training ONLY not to be used with the public

    begin by

    BEGIN BY

    ELIMINATING THE WAYS THAT MOST PEOPLE

    FAIL:

    MANAGE, REDUCE, AND

    MANAGE, REDUCE, AND ELIMINATE

    ELIMINATE

    RISK, FEES, AND TAXES.

    Training ONLY not to be used with the public

    RISK, FEES, AND TAXES.

    some common blunders

    SOME COMMON BLUNDERS

    1 TREATING FINANCIAL PLANNING LIKE A PART-TIME JOB – NOT LIKE A

    PROFESSION

    2 NOT HAVING RISK MANAGEMENT STRATEGIES.

    3 TRYING TO TIME THE MARKET(S)

    4 LETTING EMOTIONS DRIVE INVESTMENT DECISIONS...GREED AND FEAR

    5 IGNORING THE BIGGEST RISK OF ALL – OUT LIVING YOUR MONEY

    6 EXPECTING ANY APPROACH TO WORK ALL THE TIME

    7 HIRING A MANAGER SOLELY BY THE NUMBERS

    Training ONLY not to be used with the public

    some common blunders 1

    SOME COMMON BLUNDERS

    8 GETTING CAUGHT UP IN THE RELATIVE PERFORMANCE GAME

    9 NOT KNOWING WHEN TO FIRE A MANAGER

    10 NOT HAVING A FINANCIAL ADVISER... EVEN THE BEST HAVE COACHES

    11 DOING NOTHING AND PROCRASTINATION

    12 BUYING ON A “HOT TIP”

    13 BUYING LAST YEAR'S HOT INVESTMENT

    14 FORGETTING TO WATCH

    15 GETTING BONDS BACKWARDS - % UP P DOWN

    Training ONLY not to be used with the public

    some common blunders 2

    SOME COMMON BLUNDERS

    16 THINKING FIXED INCOME IS FIXED VALUE

    17 THINKING A GUARANTEE IS A GUARANTEE

    18 IGNORING TAXES

    19 PUTTING ACCOUNTS IN THE WRONG NAME

    20 NEGLECTING THE FINAL STEPS: DISTRIBUTIONS AND TRANSFERS

    21 NOT HAVING AND/OR REVIEWING A STRATEGY – A PLAN

    22 NOT PROPERLY PROTECTING ASSETS

    Training ONLY not to be used with the public

    the impact of emotion

    THE IMPACT OF EMOTION

    Training ONLY not to be used with the public

    average investor

    AVERAGE INVESTOR

    Training ONLY not to be used with the public

    emh efficient market hypothesis

    EMH - EFFICIENT MARKET HYPOTHESIS

    • A CHALLENGE TO THE EFFICIENT MARKET HYPOTHESIS

    ASSUMPTIONS:

    MARKETS ARE INFORMATIONALLY EFFICIENT.

    INVESTORS BEHAVE RATIONALLY WITHIN THE MARKET, AND

    WILL NOT PAY TOO MUCH FOR A SECURITY NOR SELL A

    SECURITY FOR TOO LITTLE.

    Training ONLY not to be used with the public

    reasons why

    REASONS WHY

    • LOSS AVERSION

    • FEAR OF REGRET

    • OVERCONFIDENCE

    • REPRESENTATIVENESS

    • FRAMING THE PROBLEM

    • RATIONALIZATION

    • HINDSIGHT BIAS

    • ANCHORING

    • RECENCY

    • MENTAL ACCOUNTING

    • MONEY ILLUSION

    • AVAILABILITY BIAS

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    emh efficient market hypothesis 1

    EMH - EFFICIENT MARKET HYPOTHESIS

    BUT IF INVESTORS DO BEHAVE RATIONALLY,

    HOW DO YOU EXPLAIN EXTREMES SUCH AS THE MARKET CRASH ON OCTOBER 19,

    1987

    2000 - 2005?

    THE PANIC SELLING IN MARKET IN 2001 AND 2008?

    MARKET CRASH ON OCTOBER 19,

    1987? OR THE RUN

    RUN- -UP IN REAL ESTATE

    UP IN REAL ESTATE PRICES IN MANY AREAS OF THE COUNTRY

    CAN WE SO READILY DISCOUNT THE IMPACT OF HUMAN EMOTIONS IN

    THE MARKETPLACE?.

    THE IMPACT OF HUMAN EMOTIONS IN

    THE MARKETPLACE?.

    Training ONLY not to be used with the public

    emh efficient market hypothesis 2

    EMH - EFFICIENT MARKET HYPOTHESIS

    • WHAT IMPACT DOES FEAR AND GREED HAVE ON HUMAN BEHAVIOR, AND

    SUBSEQUENTLY THE MARKETS?

    THE STUDY OF INVESTOR BEHAVIOR IS KNOWN AS BEHAVIORAL FINANCE

    IT HAS BEEN GAINING IN MOMENTUM AND IMPORTANCE.

    BEHAVIORAL FINANCE, AND

    Training ONLY not to be used with the public

    emh efficient market hypothesis 3

    EMH - EFFICIENT MARKET HYPOTHESIS

    IN 2002 A NOBEL PRIZE IN ECONOMIC WAS AWARDED TO DANIEL KAHNEMAN,

    WHOSE WORK INVOLVED INTEGRATING BOTH ECONOMICS AND PSYCHOLOGY.

    MORE PRACTITIONERS ARE BECOMING AWARE OF ITS VALUE IN HELPING THEIR

    CLIENTS AVOID SOME OF

    BEHAVIORAL FINANCE LOOKS AT THE EMOTIONS, IRRATIONAL DECISION

    AND BIASES

    MONEY.

    AWARE OF ITS VALUE IN HELPING THEIR

    THE COMMON SELF- -DESTRUCTIVE MONEY “TRAPS.”

    THE EMOTIONS, IRRATIONAL DECISION- -MAKING,

    AND BIASES THAT CAN COME INTO PLAY WHEN INDIVIDUALS INVEST AND HANDLE

    CLIENTS AVOID SOME OF THE COMMON SELF

    DESTRUCTIVE MONEY “TRAPS.”

    MAKING,

    Training ONLY not to be used with the public

    here are the most common behavioral emotions

    HERE ARE

    THE MOST

    COMMON

    BEHAVIORAL

    EMOTIONS AND

    MISTAKES

    INVESTORS MAKE:

    MOST

    COMMON

    MISTAKES THAT

    Training ONLY not to be used with the public

    loss aversion

    LOSS AVERSION

    • INVESTORS HATE TO TAKE LOSSES.

    THE DEGREE TO WHICH INVESTORS ARE AVERSE TO TAKING LOSSES WAS

    ILLUMINATED IN A 1979 STUDY BY KAHNEMAN AND TVERSKY.

    THEY FOUND THAT A LOSS HAS ABOUT 2.5 TIMES THE IMPACT OF A GAIN

    THE SAME MAGNITUDE.

    LOSS AVERSION, WHICH IS RELATED TO FEAR OF REGRET, EXPLAINS WHY MANY

    INVESTORS WILL NOT SELL

    INSTEAD, IF REQUIRED TO SELL SOMETHING, THEY SELL THOSE SECURITIES IN

    WHICH THEY HAVE A PROFIT, THE OPPOSITE

    “CUT YOUR LOSSES AND LET PROFITS RUN” STRATEGY RECOMMENDED BY MANY

    SAVVY INVESTORS.

    A LOSS HAS ABOUT 2.5 TIMES THE IMPACT OF A GAIN OF

    WILL NOT SELL ANYTHING AT A LOSS

    AT A LOSS.

    THE OPPOSITE OF THE

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    loss aversion 1

    LOSS AVERSION

    • THE TENDENCY TO KEEP LOSING INVESTMENTS AND SELL PROFITABLE

    INVESTMENTS IS CALLED THE DISPOSITION EFFECT.

    SELLING AT A LOSS NOT ONLY ADMITS A MISTAKE, BUT ALSO ENDS ANY HOPE

    OF AT LEAST GETTING BACK EVEN.

    INVESTMENT PROFESSIONALS OFTEN HEAR FROM CLIENTS WHO STATE THAT

    RATHER THAN SELLING AT A LOSS, THEY WILL SELL WHEN THE STOCK GETS

    BACK TO THE PRICE AT WHICH THEY BOUGHT IT.

    THIS “GET-EVEN” ATTITUDE CAN BE VERY HARMFUL TO INVESTMENT RESULTS

    BECAUSE SOME STOCKS NEVER WILL GET BACK

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    loss aversion 2

    LOSS AVERSION

    BECAUSE SOME STOCKS NEVER WILL GET BACK TO WHERE AN INVESTOR BOUGHT

    THEM, OR

    AT LEAST WILL TAKE A VERY LONG TIME TO DO SO.

    IN THE MEANTIME, BETTER INVESTMENTS ARE PASSED BY WHILE WAITING FOR THE

    STOCK TO REBOUND.

    IN THIS CASE, WHAT AN INVESTOR DOES NOT DO

    HE OR SHE DOES.

    INVESTOR DOES NOT DO CAN BE AS HARMFUL AS WHAT

    SHE DOES.

    Training ONLY not to be used with the public

    fear of regret

    FEAR OF REGRET

    MARK TWAIN ONCE WROTE:

    “TWENTY YEARS FROM NOW YOU WILL BE MORE DISAPPOINTED BY THE THIN

    YOU DIDN’T DO THAN BY THE ONES YOU DID DO.”

    “TWENTY YEARS FROM NOW YOU WILL BE MORE DISAPPOINTED BY THE THINGS

    YOU DIDN’T DO THAN BY THE ONES YOU DID DO.”

    GS

    REGRET IS A VERY STRONG HUMAN EMOTION.

    FEAR OF REGRET MAY DRIVE SOMEONE TO BUY THE LATEST “HOT STOCK”

    BECAUSE OF THE FEAR OF MISSING AN OPPORTUNITY.

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    fear of regret 1

    FEAR OF REGRET

    REGRET IS MORE THAN EXPERIENCING THE PAIN OF A LOSS.

    REGRET INVOLVES THE PAIN OF FEELING RESPONSIBLE FOR THE LOSS.

    INVESTORS CAN AVOID NOT ONLY THE LOSS BUT THE FEELING OF REGRET IF THEY

    CAN HOLD ON TO A POORLY PERFORMING STOCK UNTIL IT GETS BACK TO WHERE HE

    OR SHE BOUGHT IT. OF COURSE, THIS MAY NOT BE THE BEST INVESTMENT DECISION

    BECAUSE SOME STOCKS NEVER COME BACK OR AT LEAST TAKE SEVERAL YEARS TO

    COME BACK. USUALLY,

    THERE IS MORE REGRET ASSOCIATED WITH TAKING AN ACTION THAT TURNS OUT

    POORLY THAN WITH NOT TAKING AN ACTION THAT WOULD HAVE BENEFITED THE

    INVESTOR.

    Training ONLY not to be used with the public

    fear of regret 2

    FEAR OF REGRET

    ONE WAY TO APPROACH AN INVESTOR WITH THIS MIND-SET IS TO ASK IF HE OR

    SHE WOULD LIKE TO BUY MORE OF THE SAME SECURITY.

    A TYPICAL RESPONSE MIGHT BE, “ARE YOU CRAZY?

    THIS DOG!” TO WHICH THE ADVISOR CAN GENTLY ASK, “IF YOU THINK IT’S A DOG

    AND YOU WOULDN’T BUY IT HERE, WHY DO YOU THINK IT IS A GOOD

    INVESTMENT TO HOLD?”

    IF THE ADVISOR CAN HELP THE CLIENT ADMIT THAT THE OUTLOOK FOR THE

    SECURITY’S PERFORMANCE IS POOR, THE CLIENT MAY BE MORE INCLINED TO SELL

    THE SECURITY AND PUT THE CASH FROM THE SALE TO WORK IN ANOTHER

    INVESTMENT.

    Training ONLY not to be used with the public

    LIKE TO BUY MORE OF THE SAME SECURITY.

    “ARE YOU CRAZY? I WOULDN’T BUY ANY MORE OF

    overconfidence

    OVERCONFIDENCE

    • IF ANALYSTS FORECAST THAT A STOCK WILL INCREASE IN VALUE WITH 80% CONFIDENCE,

    THEY ARE RIGHT ABOUT 40% OF THE TIME.

    ASK ANYONE IF THEY ARE AN ABOVE

    SAY THEY ARE ABOVE-AVERAGE.

    OTHER RESEARCH SHOWS SIMILAR EVIDENCE IN OTHER AREAS OF HUMAN BEHAVIOR,

    INCLUDING OVERESTIMATES OF LEADERSHIP ABILITY, ATHLETICISM, AND COMPETENCE. WITH

    INVESTOR BEHAVIOR, THIS OVERCONFIDENCE CAN LEAD TO ILLUSIONS OF CONTROL

    CAN LEAD TO BIASED JUDGMENTS, INVESTING TOO MUCH IN INVESTMENTS ABOUT WHICH

    THEY KNOW TOO LITTLE, TAKING UNDUE RISKS, AND FAILURE TO REALIZE THEY ARE AT AN

    INFORMATIONAL DISADVANTAGE TO INSTITUTIONAL INVESTORS. DURING STRONG BULL

    MARKETS, IT IS EASY FOR INVESTORS TO CREDIT THEMSELVES FOR THEIR STRONG

    PERFORMANCE AND IGNORE THE CONTRIBUTION OF THE BULL MARKET ITSELF TO THAT

    STRONG PERFORMANCE. SUCCESSFUL INVESTING DECISIONS CAN BECOME A

    WITH 80% CONFIDENCE,

    THEY ARE RIGHT ABOUT 40% OF THE TIME.

    ABOVE- -AVERAGE OR BELOW

    AVERAGE OR BELOW- -AVERAGE

    AVERAGE DRIVER AND MOST WILL

    LEAD TO ILLUSIONS OF CONTROL THAT

    Training ONLY not to be used with the public

    overconfidence 1

    OVERCONFIDENCE

    SOURCE OF PRIDE AND EGO GRATIFICATION, AND THE MODERN-DAY EQUIVALENT

    OF A SUCCESSFUL HUNTER DURING THE CAVEMAN DAYS. A CONSEQUENCE OF

    THIS CAN BE NOT MEETING FINANCIAL GOALS.

    IF INVESTORS ARE OVERCONFIDENT ABOUT THE RETURNS THEY EXPECT TO GET,

    THEY MAY SAVE AND INVEST LESS THAN THEY OTHERWISE WOULD.

    THEN IF THOSE EXPECTED RETURNS ARE NOT REALIZED, THEY COULD VERY WELL

    COME UP SHORT OF ACHIEVING THOSE GOALS. THIS IS PARTICULARLY RELEVANT

    AS BABY BOOMERS ARE APPROACHING RETIREMENT.

    Training ONLY not to be used with the public

    overconfidence 2

    OVERCONFIDENCE

    OVERCONFIDENCE CAN ALSO MASK ERRORS INVESTORS MAKE. SO INSTEAD OF

    LEARNING FROM THEIR ERRORS, INVESTORS ATTRIBUTE POOR INVESTMENT

    RESULTS NOT TO THEIR OWN MISTAKES, BUT TO SOME OTHER CAUSE OVER

    WHICH THEY HAVE NO CONTROL.

    FOR EXAMPLE, WITH THE MELTDOWN OF TECHNOLOGY STOCKS IN THE 2000–

    2002 PERIOD, SOME INVESTORS BLAMED THEIR LOSSES ON POOR

    RECOMMENDATIONS FROM BROKERAGE FIRMS OR A “BAD MARKET” RATHER THAN

    THEIR BUYING STOCKS OF COMPANIES WITH POOR BUSINESS PLANS AND P/ES

    APPROACHING 100, OR EVEN COMPANIES WITH NO EARNINGS AND PRICE-TO-

    SALES RATIOS OF 40 TO 50. THESE GROSSLY INFLATED VALUATIONS WERE

    REASON ENOUGH FOR INVESTORS TO AVOID SUCH STOCKS.

    Training ONLY not to be used with the public

    overconfidence 3

    OVERCONFIDENCE

    • ANOTHER ASPECT OF OVERCONFIDENCE IS “OPTIMISTIC BIAS,” WHICH IS THE TENDENCY FOR AN

    INVESTOR TO BE CONVINCED THAT HE OR SHE WILL DO BETTER THAN OTHER INVESTORS

    HOWEVER, INVESTING IS A ZERO SUM GAME IN THAT FOR EVERY SELLER THERE IS A BUYER, SO IF

    ONE MADE THE CORRECT DECISION THE OTHER DID NOT.

    • OVERCONFIDENCE IS OFTEN MANIFESTED IN OVERTRADING BY INVESTORS, AND ESPECIALLY BY

    MALE INVESTORS.

    A 1998 STUDY BY BRAD BARBER AND TERRANCE ODEAN, WHICH ANALYZED THE TRADING

    HISTORIES OF 60,000 INVESTORS OVER A SIX-YEAR PERIOD ENDING IN 1996, REVEALED THAT THE

    INDIVIDUALS BEAT THE VALUE-WEIGHTED MARKET INDEX BY 60 BASIS POINTS (1% = 100 BASIS

    POINTS), GROSS OF TRADING COSTS. HOWEVER, TRADING COSTS WERE 240 BASIS POINTS,

    RESULTING IN UNDERPERFORMANCE COMPARED TO THE INDEX.

    FURTHERMORE, INDIVIDUALS WHO TRADED THE MOST HAD THE WORST PERFORMANCE,

    UNDERPERFORMING THE INDEX BY 500 BASIS POINTS.

    •Training ONLY not to be used with the public

    CONVINCED THAT HE OR SHE WILL DO BETTER THAN OTHER INVESTORS.

    overconfidence 4

    OVERCONFIDENCE

    IN GENERAL, THERE IS NO CORRELATION BETWEEN CONFIDENCE AND BETTER

    PERFORMANCE. THIS WAS CLEARLY DEMONSTRATED BETWEEN 1999 AND 2001

    WHEN INVESTORS GENERALLY, AND DAY TRADERS PARTICULARLY, WERE

    EXCEEDINGLY CONFIDENT IN 1999 AND EARLY 2000 ONLY TO ENCOUNTER

    SIGNIFICANT LOSSES BY THE FIRST QUARTER OF 2001 AND, IN THE CASE OF

    NUMEROUS TECHNOLOGY STOCKS, HUGE LOSSES. EVEN MANY PROFESSIONAL

    MONEY MANAGERS BECOME OVERCONFIDENT AND END UP UNDERPERFORMING

    THE MARKET, AS WAS SEEN WITH THE PERFORMANCE OF MANY MUTUAL FUNDS

    DURING THIS TIME PERIOD.

    Training ONLY not to be used with the public

    representativeness

    REPRESENTATIVENESS

    • REPRESENTATIVENESS INVOLVES MAKING JUDGMENTS BASED ON STEREOTYPES.

    IT IS A METHOD THE BRAIN USES TO CLASSIFY THINGS RAPIDLY AND THEREBY

    CREATES SHORTCUTS. YOU CAN SEE A CLASSIC EXAMPLE OF THIS IN POLITICS. IF

    YOU HAVE TWO INDIVIDUALS, ONE FROM THE RIGHT AND ANOTHER FROM THE

    LEFT, AND HAVE THEM WATCH THE SAME POLITICAL PROGRAM, THEY WILL

    HAVE DIFFERENT OPINIONS OF THE OBJECTIVITY AND FAIRNESS OF THE

    PROGRAM.

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    representativeness 1

    REPRESENTATIVENESS

    • AS APPLIED TO INVESTMENTS, REPRESENTATIVENESS APPEARS WHEN INVESTORS

    BECOME OVERLY NEGATIVE ABOUT INVESTMENTS THAT HAVE DONE POORLY IN

    THE PAST AND OVERLY POSITIVE ABOUT INVESTMENTS THAT HAVE DONE WELL

    IN THE PAST. FROM THIS, STOCKS, IN PARTICULAR, CAN BECOME UNDERVALUED

    AND OVERVALUED RESPECTIVELY. WITH MUTUAL FUNDS, THE SEC TRIES TO

    HELP MUTUAL FUND INVESTORS AVOID

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    representativeness 2

    REPRESENTATIVENESS

    REPRESENTATIVENESS WITH ITS PROSPECTUS STATEMENT THAT “PAST

    PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.” YET THE TRACKING OF NEW

    CASH FLOW INTO MUTUAL FUNDS ALMOST ALWAYS SHOWS INVESTOR MONEY

    CHASING THOSE FUNDS WITH HIGH RATES OF RETURN DURING THE LAST ONE,

    THREE, OR FIVE YEARS. THIS TENDENCY OFTEN RESULTS IN INVESTORS BUYING

    AFTER THE FUNDS HAVE HAD THEIR BEST PERFORMANCE. INVESTORS FORM A BIAS

    AND BELIEVE THAT A FUND MANAGER WHO PERFORMED WELL IN A PRIOR PERIOD OF

    TIME HAS A GOOD CHANCE OF CONTINUING TO PERFORM WELL IN THE FUTURE.

    REPRESENTATIVENESS, THEN, CAN BE A MISLEADING GUIDE TO FUTURE INVESTMENT

    PERFORMANCE.

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    representativeness 3

    REPRESENTATIVENESS

    • IN ADDITION, INDIVIDUALS PLACE TOO MUCH VALUE ON WHAT THEY KNOW BASED ON THEIR

    EXPERIENCES— THIS FAMILIARITY CAN BE CONFUSED WITH KNOWLEDGE. THIS EXPLAINS WHY

    INVESTORS WHO HAVE NOT INVESTED IN INTERNATIONAL SECURITIES ARE RELUCTANT TO DO SO.

    ANOTHER EXAMPLE IS EMPLOYEES ALLOCATING TOO MUCH OF THEIR COMPANY’S RETIREMENT PLAN

    TO COMPANY STOCK. OBVIOUSLY THEY ARE FAMILIAR WITH THE COMPANY SO THEY ARE

    COMFORTABLE INVESTING IN IT. WHILE THE IDEA OF “INVESTING IN WHAT YOU KNOW” MAKES

    SENSE, THE DANGER IS IN THE DIFFERENCE BETWEEN AN INVESTOR’S ACTUAL KNOWLEDGE VERSUS

    WHAT ONE THINKS HE OR SHE KNOWS. MANY EMPLOYEES UNFORTUNATELY FOUND OUT THIS

    DIFFERENCE WHEN SO MANY INTERNET AND TELECOMMUNICATION COMPANIES WENT BANKRUPT

    BETWEEN 2000 AND 2003. THIS ALSO BECAME APPARENT AGAIN IN 2008 WHEN MANY FINANCIAL

    INSTITUTIONS WENT INTO BANKRUPTCY OR WERE FORCED TO MERGE, RESULTING IN LARGE LOSSES

    FOR SHAREHOLDERS. MANY INVESTORS WERE COMFORTABLE OWNING THESE BANKS, AND HAD NO

    IDEA OF THE LARGE AMOUNT OF RISK THESE BANKS WERE TAKING, AND HOW SHAKY THE BANKS’

    FINANCIALS ACTUALLY WERE.

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    framing the problem

    FRAMING THE PROBLEM

    • FRAMING IS THE NOTION THAT IT MATTERS HOW A CONCEPT IS PRESENTED TO AN INDIVIDUAL.

    FOR EXAMPLE, ASSUME A MEAL AT A RESTAURANT NORMALLY IS PRICED AT $10. THE RESTAURANT

    MIGHT OFFER AN “EARLY BIRD SPECIAL” WHERE THAT PRICE IS $8 BEFORE 6 P.M., AND THEREBY GET

    MORE BUSINESS IF PEOPLE THINK THEY ARE GETTING A DISCOUNT. NOW ASSUME, INSTEAD, THE

    PRICE OF THE MEAL IS $8 BUT AFTER 6 P.M. THERE IS A $2 SURCHARGE. OF COURSE, THE

    RESTAURANT WILL BE PERCEIVED IN A MORE FAVORABLE FASHION BY OFFERING A DISCOUNT

    RATHER THAN A SURCHARGE EVEN THOUGH THE PRICING STRUCTURE IS IDENTICAL. IN LIKE

    MANNER, HOW AN INVESTOR VIEWS A SITUATION CAN HAVE A SIGNIFICANT IMPACT ON THE

    INVESTOR’S DECISION. INVESTORS OFTEN CHOOSE A GUARANTEED POSITIVE OUTCOME (WHILE

    AVOIDING A CHANCE OF GREATER GAIN THAT ALSO CARRIES THE POSSIBILITY OF NO GAIN AT ALL),

    BUT THEY WILL TAKE A CHANCE TO AVOID A NEGATIVE OUTCOME (RATHER THAN TAKING A

    CERTAIN SMALLER LOSS). ANOTHER ASPECT OF THIS IS WHEN AN INVESTOR FRAMES A SITUATION

    BASED ON THEIR INVESTED ASSETS. THIS IS ILLUSTRATED BY THE FOLLOWING EXAMPLES:

    Training ONLY not to be used with the public

    framing the problem 1

    FRAMING THE PROBLEM

    SCENARIO 1.

    A. YOU CAN RECEIVE ANOTHER $500 FOR SURE.

    B. YOU CAN FLIP A COIN, AND IF IT COMES UP HEADS YOU GET ANOTHER $1,000, BUT IF IT

    COMES UP TAILS YOU GET NOTHING.

    SCENARIO 1. YOU HAVE BEEN GIVEN $1,000, AND HAVE THE FOLLOWING CHOICES:

    SCENARIO 2.

    A. YOU CAN LOSE $500 FOR SURE.

    B. YOU CAN FLIP A COIN, AND IF IT COMES UP HEADS YOU LOSE $1,000, BUT IF IT COMES UP

    TAILS YOU LOSE NOTHING.

    SCENARIO 2. YOU HAVE BEEN GIVEN $2,000, AND HAVE THE FOLLOWING CHOICES:

    WHAT WERE YOUR CHOICES FOR THE TWO SCENARIOS?

    WAS YOUR CHOICE “A” IN THE FIRST SCENARIO AND “B” IN THE SECOND? IF SO, YOU ARE GUILTY

    OF JUST FOCUSING ON GAINS AND LOSSES, AND NOT LOOKING AT THE OVERALL BIG PICTURE

    AND THE EFFECT ON YOUR WEALTH. ABOUT 85% OF PEOPLE CHOOSE OPTION “A” IN THE FIRST

    SCENARIO, AND ABOUT 70% OF PEOPLE CHOOSE OPTION “B” IN THE SECOND SCENARIO.

    framing the problem 2

    FRAMING THE PROBLEM

    • IF YOU TAKE A CLOSE LOOK AT BOTH SCENARIOS YOU WILL SEE THAT THEY ARE

    ACTUALLY IDENTICAL.

    FOR BOTH SCENARIOS YOU WILL END UP WITH $1,500 FOR SURE IF YOU PICK

    OPTION “A,” OR ELSE HAVE A 50/50 CHANCE OF EITHER ENDING UP WITH $1,000 OR

    $2,000

    IF YOU PICK OPTION “B.” SO YOU SHOULD PICK THE SAME OPTION UNDER EITHER

    SCENARIO. WHICH OPTION YOU PREFER IS UP TO YOU, BUT IF YOU PICK “A” IN THE

    FIRST SCENARIO YOU SHOULD ALSO PICK “A” IN THE SECOND, OR IF YOU PICK “B” IN

    ONE SCENARIO YOU SHOULD PICK IT IN THE OTHER. PEOPLE PICK DIFFERENT

    ANSWERS BECAUSE OF HOW THE QUESTIONS ARE ASKED—IN OTHER WORDS HOW

    THEY ARE “FRAMED.” GENERALLY, INVESTORS ARE BETTER OFF FRAMING A DECISION

    IN BROAD TERMS BASED ON OVERALL WEALTH, RATHER THAN IN NARROWER TERMS

    BASED ON GAINS AND LOSSES.

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    framing the problem 3

    FRAMING THE PROBLEM

    ONE FINAL EXAMPLE: DEPARTMENT STORES HAVE BECOME MASTERS AT FRAMING

    WITH SALES THAT NEVER END.

    YOU FEEL MUCH BETTER BUYING A $50 SHIRT FOR $35,

    THEN BUYING THE SAME SHIRT PRICED AT $35 AS THE “NORMAL” PRICE.

    IN EITHER CASE YOU ARE OUT OF POCKET $35 FOR THE SAME SHIRT.

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    rationalization

    RATIONALIZATION

    • INVESTORS SEARCH FOR AND RELY ON INFORMATION THAT SUPPORTS THEIR

    DECISIONS.

    THE TENDENCY TO GIVE TOO MUCH IMPORTANCE TO INFORMATION THAT

    CONFIRMS ONE’S IMPRESSIONS OR PREFERENCES IS CALLED CONFIRMATION

    BIAS.

    “BAD NEWS” AND FACTS THAT MIGHT CHALLENGE ONE’S OPINIONS TEND TO BE

    IGNORED

    Training ONLY not to be used with the public

    rationalization 1

    RATIONALIZATION

    IN RESEARCH CIRCLES, THIS CAN BE REFERRED TO AS DATA MINING (REPORTING

    ONLY EVIDENCE THAT SUPPORTS YOUR CASE).

    IN INVESTMENT CIRCLES, RATIONALIZATION OFTEN OCCURS WHEN ONE ANALYST

    GIVES A BUY SIGNAL WHILE ANOTHER GIVES A SELL SIGNAL; BOTH CANNOT BE

    RIGHT.

    BUT BOTH WILL POINT TO CONVINCING EVIDENCE—SOMETIMES EVEN THE SAME

    EVIDENCE WITH A DIFFERENT SPIN—TO SUPPORT THEIR POSITIONS.

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    hindsight bias

    HINDSIGHT BIAS

    THIS IS THE CHARACTERISTIC OF INVESTORS, WHEN LOOKING BACK, SEEING

    EVENTS THAT TOOK PLACE IN THE PAST AS HAVING BEEN MORE PREDICTABLE

    THAN THEY SEEMED BEFORE THEY HAPPENED. LIKEWISE, THINGS THAT DIDN’T

    HAPPEN SEEM, WITH HINDSIGHT, MUCH LESS LIKELY TO HAVE HAPPENED THAN

    THEY DID BEFOREHAND. IN OTHER WORDS, THERE IS A RECONCILIATION OF A

    PERSON’S BELIEFS BASED ON THE OUTCOME OF EVENTS. FOR EXAMPLE,

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    hindsight bias 1

    HINDSIGHT BIAS

    IF A FINANCIAL PROFESSIONAL RECOMMENDS AN INVESTMENT THAT DOES WELL,

    A CLIENT TENDS TO THINK OF THAT RECOMMENDATION AS ONE HE OR SHE LIKED

    FROM THE START, EVEN IF THAT WAS NOT THE CASE.

    WITH RECOMMENDATIONS THAT DO NOT TURN OUT WELL, HOWEVER, THE

    CLIENT OFTEN THINKS THAT HE OR SHE HAD DOUBTS TO BEGIN WITH ABOUT

    THEM, EVEN WHEN, IN FACT, THAT WAS NOT TRUE. THIS THINKING RESULTS IN A

    CLIENT GIVING LESS CREDIT TO THE INVESTMENT PROFESSIONAL FOR GOOD

    RECOMMENDATIONS AND MORE BLAME FOR RECOMMENDATIONS THAT DO NOT

    WORK OUT.

    Training ONLY not to be used with the public

    hindsight bias 2

    HINDSIGHT BIAS

    THE STOCK MARKET SELL-OFF IN 2008 CAN BE SEEN AS A CLASSIC EXAMPLE OF

    HINDSIGHT BIAS. LOOKING BACK ONE MIGHT THINK THEY SHOULD HAVE BEEN

    ABLE TO TELL THAT THE MARKET WAS GOING TO CORRECT DRAMATICALLY

    BECAUSE OF THE SUB-PRIME MARKET AND DECLINE IN REAL ESTATE PRICES. BUT

    HOW WAS ONE TO KNOW

    • HOW LONG IT WOULD LAST?

    HOW COULD ONE HAVE PREDICTED THE CREDIT CRUNCH AND SUBSEQUENT

    GOVERNMENT BAILOUTS?

    EVERYTHING IS ALWAYS CLEARER IN THE REARVIEW MIRROR.

    Training ONLY not to be used with the public

    anchoring

    ANCHORING

    • ANCHORING REFERS TO THE TENDENCY TO HOLD TO CERTAIN BELIEFS EVEN

    WHEN FACED WITH NEW INFORMATION THAT SHOULD ALTER THOSE BELIEFS,

    THEREBY CREATING, IN EFFECT, TUNNEL VISION.

    Training ONLY not to be used with the public

    anchoring 1

    ANCHORING

    • IN OTHER WORDS, INVESTORS START AT AN INITIAL MENTAL REFERENCE POINT

    BASED ON PAST EXPERIENCE. THIS MIGHT LEAD TO OVERWEIGHTING IRRELEVANT

    DATA OR SLOWLY ADJUSTING TO A CORRECT ANSWER OR DECISION AS THEY

    RECEIVE ADDITIONAL INFORMATION. AS APPLIED TO THE ANNOUNCEMENT OF A

    COMPANY’S EARNINGS, ANCHORING RESULTS IN SECURITY ANALYSTS

    UNDERREACTING TO UNEXPECTED EARNINGS ANNOUNCEMENTS. THIS DOES NOT

    MEAN THERE IS NOT A REACTION, BECAUSE SUCH ANNOUNCEMENTS TYPICALLY

    MOVE THE STOCK QUICKLY AND, IN SOME CASES, SIGNIFICANTLY. IT DOES MEAN

    THAT SECURITY ANALYSTS DO NOT REVISE THEIR EARNINGS ESTIMATES ENOUGH TO

    REFLECT THIS NEW INFORMATION. AS A RESULT, POSITIVE OR NEGATIVE EARNINGS

    SURPRISES TEND TO BE FOLLOWED BY MORE POSITIVE OR NEGATIVE EARNINGS

    SURPRISES.

    Training ONLY not to be used with the public

    anchoring 2

    ANCHORING

    • INDIVIDUAL INVESTORS, OF COURSE, ALSO EXPERIENCE ANCHORING. THEIR

    INVESTMENT EXPERIENCES CREATE BELIEFS THAT THEY SUBSEQUENTLY RELY ON,

    AND THEN THEY UNDERREACT TO NEW INFORMATION. ONE OF MOST VIVID

    EXAMPLES OF THIS CAN BE SEEN BY EXAMINING INVESTOR CONDUCT WITH

    TECHNOLOGY STOCKS IN THE LATE 1990S. IT APPEARED THAT INVESTORS COULD

    DO NO WRONG BY BUYING TECHNOLOGY STOCKS AND, NO MATTER WHAT PRICES

    WERE PAID, TECHNOLOGY STOCK PRICES WOULD BE HIGHER IN THE FUTURE.

    HOWEVER, EVEN THOUGH VALUATIONS WENT TO EXTREMES AND IT BECAME

    EVIDENT THAT THE PROSPECT OF ANY EARNINGS FOR MANY OF THESE COMPANIES

    WAS WELL IN THE FUTURE, IF EVER, MANY INVESTORS DID

    • NOT REACT TO THIS INFORMATION. BY THE END OF 2002, THE COST OF

    ANCHORING TO THESE STOCKS’ PRICES WAS OBVIOUS.

    Training ONLY not to be used with the public

    recency

    RECENCY

    • THIS IS THE PROBLEM OF PUTTING TOO MUCH WEIGHT ON CURRENT EVENTS OR

    DATA AND NOT ENOUGH WEIGHT ON PAST, HISTORIC TRENDS. MANY

    INVESTORS EXPECT THE MARKET TO CONTINUE RISING IN A CURRENT BULL

    MARKET; LIKEWISE, THESE SAME INVESTORS OFTEN EXPECT A CURRENT BEAR

    MARKET TO GET WORSE. RECENCY IS SHOWN IN MOMENTUM INVESTING WHEN

    INVESTORS BUY “HOT” STOCKS SIMPLY ON THE BASIS OF THEIR RECENT STRONG

    PERFORMANCE. ONE DIFFERENCE BETWEEN RECENCY AND REPRESENTATIVENESS

    IS THAT RECENCY INVOLVES A SHORTER, MORE RECENT TIME FRAME THAN

    REPRESENTATIVENESS.

    Training ONLY not to be used with the public

    recency 1

    RECENCY

    AN EXAMPLE OF RECENCY OCCURRED IN THE 1990S BULL MARKET. AT THAT TIME

    THERE WERE MANY INDIVIDUALS PROJECTING ANNUAL RETURNS OF 20% OR

    GREATER IN THEIR RETIREMENT ACCOUNTS BASED ON THE RECENT

    PERFORMANCE OF THE STOCK MARKET, EVEN THOUGH HISTORICAL RETURNS

    WERE HALF THAT AMOUNT. ANOTHER GOOD EXAMPLE OF RECENCY IS THE

    MARKET SELL-OFF IN 2008. WITH THE OVERALL MARKET DOWN OVER 40% FOR

    THE YEAR, GOING INTO THE PRESIDENTIAL ELECTIONS MANY INVESTORS WERE

    EITHER SELLING STOCKS OR NO LONGER INVESTING IN STOCKS IN THEIR

    RETIREMENT ACCOUNTS. RECENT EVENTS HAD IMPACTED THEIR OUTLOOK, AND

    THE CONCERN WAS THAT THE MARKET WAS GOING TO CONTINUE GOING DOWN

    INDEFINITELY.

    Training ONLY not to be used with the public

    recency 2

    RECENCY

    THIS IS THE OPPOSITE OF WHAT OCCURRED IN THE 1990S. IN THE 1990S WE HAD

    EXTREME OPTIMISM AND UNREALISTICALLY HIGH LONG-TERM EXPECTATIONS,

    WHEREAS IN 2008 WE EXPERIENCED EXTREME PESSIMISM AND UNREALISTICALLY

    LOW LONG-TERM EXPECTATIONS.

    Training ONLY not to be used with the public

    mental accounting

    MENTAL ACCOUNTING

    • MENTAL ACCOUNTING INVOLVES TREATING ONE DOLLAR DIFFERENT FROM ANOTHER DEPENDING

    ON WHERE IT COMES FROM, WHERE IT IS KEPT, AND HOW IT IS SPENT. THIS CAN LEAD TO BEING

    TOO QUICK TO SPEND, TOO SLOW TO SAVE, AND TOO CONSERVATIVE OR AGGRESSIVE WITH

    INVESTING. FOR EXAMPLE, RECEIVING A GIFT FROM A GRANDPARENT SEEMS MORE VALUABLE THAN

    THE SAME DOLLAR AMOUNT EARNED FROM A JOB. SO

    • THAT GIFT MIGHT BE INVESTED MORE CONSERVATIVELY THAN MONEY EARNED BECAUSE LOSING

    “GRANDMA’S” MONEY WOULD BE MORE TRAUMATIC THAN LOSING ONE’S OWN MONEY. MENTAL

    ACCOUNTING CAN ALSO BE AFFECTED BY THE AMOUNT OF MONEY INVOLVED. FOR EXAMPLE, MOST

    PEOPLE WOULD GO TO GREATER LENGTHS TO SAVE $25 ON A $100 PURCHASE THAN THEY WOULD

    TO SAVE $25 ON A $1,000 PURCHASE—THE

    • $25 SEEMS TO HAVE MORE VALUE WITH THE $100 PURCHASE.

    Training ONLY not to be used with the public

    mental accounting 1

    MENTAL ACCOUNTING

    • MENTAL ACCOUNTING IS THE REASON INVESTORS DIVIDE THEIR ASSETS INTO DIFFERENT POCKETS

    AND THEREFORE INTERFERES WITH THEM THINKING OF THEIR OVERALL PORTFOLIO. TO ILLUSTRATE

    THIS CONCEPT, ASSUME A PERSON INVESTS $1,000 IN A SPECULATIVE STOCK AND IN TWO MONTHS

    SELLS THE INVESTMENT FOR $4,000. WITH MENTAL ACCOUNTING, THE INVESTOR WILL THEN BE

    MORE CONSERVATIVE WHEN REINVESTING THE

    • $1,000 (SINCE THAT WAS HIS “REAL” INVESTMENT) AND TEND TO TAKE GREATER RISKS WITH THE

    $3,000

    • PROFIT. THIS IS CALLED THE “HOUSE MONEY EFFECT,” BECAUSE IT IS SIMILAR TO A GAMBLER

    THINKING OF THE

    • $3,000 AS THE “HOUSE’S MONEY” AND IF IT IS LOST, WELL, IT WASN’T REALLY THE GAMBLER’S

    MONEY TO BEGIN WITH. OF COURSE, THE $3,000 REALLY IS THE INVESTOR’S (OR GAMBLER’S)

    MONEY, BUT IT IS THOUGHT OF DIFFERENTLY. THIS COMPARTMENTALIZATION NOT ONLY

    DISTRACTS FROM CONSIDERING THE TOTAL PORTFOLIO, BUT ALSO GETS THE INVESTOR TO

    THINKING OF HIS OR HER INVESTMENTS IN TERMS OF INDIVIDUAL WINNERS AND LOSERS RATHER

    THAN IN THEIR ENTIRETY.

    Training ONLY not to be used with the public

    money illusion

    MONEY ILLUSION

    • MONEY ILLUSION IS THE MISUNDERSTANDING PEOPLE HAVE IN RELATING NOMINAL RATES OR PRICES

    WITH REAL (INFLATION-ADJUSTED) RATES OR PRICES. FOR EXAMPLE, IF AN INVESTOR IS GIVEN THE

    CHOICE OF A 10% GAIN WHEN INFLATION IS 12% OR A 4% GAIN WHEN INFLATION IS 2%, MOST

    INVESTORS WOULD SELECT THE

    • 10% GAIN. IN REAL TERMS, HOWEVER, THE INVESTOR WOULD BE BETTER IN THE 2% INFLATION

    SCENARIO. THIS

    • EXAMPLE ALSO RELATES TO THE FACT THAT PEOPLE CAN MORE EASILY DISMISS SMALL NUMBERS

    WITHOUT

    PUTTING THEM INTO THE CORRECT FINANCIAL PERSPECTIVE. THIS MISUNDERSTANDING CAN LEAD

    TO INCORRECT FINANCIAL DECISIONS OR CLOUD THEIR FINANCIAL JUDGMENT.

    Training ONLY not to be used with the public

    availability bias

    AVAILABILITY BIAS

    • THIS BIAS CENTERS ON GIVING MORE IMPORTANCE TO DATA OR INFORMATION

    THAT IS EASY TO OBTAIN. FOR EXAMPLE, IN AN ANNUAL REPORT, IT IS EASY TO

    FIND THE EARNINGS PER SHARE FOR A COMPANY, BUT READING THE FINANCIAL

    FOOTNOTES TAKES MORE EFFORT TO INTERPRET.

    Training ONLY not to be used with the public

    availability bias 1

    AVAILABILITY BIAS

    BEHAVIORAL FINANCE CONTINUES TO EVOLVE AND WILL BECOME MORE IMPORTANT

    FOR FINANCIAL PLANNERS IN THE YEARS TO COME. BY HAVING A GOOD

    UNDERSTANDING OF THE BASICS OF BEHAVIORAL FINANCE, ADVISORS CAN NOT ONLY

    BECOME BETTER INVESTORS THEMSELVES, BUT THEY CAN ALSO HELP THEIR CLIENTS

    BECOME BETTER INVESTORS. ADVISORS WHO SPOT THESE BEHAVIORS IN THEIR

    CLIENTS CAN EDUCATE THEM ON WHAT IS HAPPENING AND WHY. THEN THEIR CLIENTS

    CAN BECOME MORE SUCCESSFUL LONG-TERM INVESTORS. UNLIKE THE EFFICIENT

    MARKET HYPOTHESIS THAT ASSUMES ALL INVESTORS ARE RATIONAL, BEHAVIORAL

    FINANCE TAKES INTO ACCOUNT THAT WE ARE ALL HUMAN AND PRONE TO OUR

    EMOTIONS, AND THAT WE DO NOT NECESSARILY ALWAYS ACT IN OUR OWN BEST

    INTERESTS.

    Training ONLY not to be used with the public

    availability bias 2

    AVAILABILITY BIAS

    BEHAVIORAL FINANCE IS GAINING WIDER ACCEPTANCE IN THE FINANCIAL

    PLANNING FIELD, ESPECIALLY IN LIGHT OF THE RECENT CREDIT CRISIS.

    EVERYTHING CANNOT BE QUANTIFIED AND REDUCED TO FORMULAS AND

    NUMBERS—THE MARKETS ARE CREATED AND USED BY HUMANS, WHO ARE NOT

    PERFECT. WE ALL HAVE VARIOUS EMOTIONS, AND WE DO NOT ALWAYS BEHAVE

    RATIONALLY. AS WE SAW WITH MODERN PORTFOLIO THEORY, A BASIC

    ASSUMPTION IS THAT INVESTORS BEHAVE RATIONALLY, ALWAYS DOING WHAT IS

    IN THEIR BEST INTEREST. THIS IS NOT NECESSARILY THE CASE.

    Training ONLY not to be used with the public

    behavioral finance

    BEHAVIORAL FINANCE

    BEHAVIORAL FINANCE WILL ENABLE ADVISORS TO HELP THEIR CLIENTS AVOID

    COMMON BEHAVIORAL TRAPS.

    BEHAVIOR AS INVESTORS, WHETHER RATIONAL OR NOT, HAS AN IMPACT ON THE

    MARKET.

    AVOID

    COMMON BEHAVIORAL TRAPS.

    THE SAME APPLIES TO INSTITUTIONAL INVESTORS: IF THEY ALL HEAD FOR THE EXIT AT

    THE SAME TIME, WHICH ESSENTIALLY HAPPENED IN THE CREDIT CRISIS IN 2008, THEN

    THE MARKETS WILL NO LONGER BEHAVE THE WAY THAT THE FORMULAS AND

    NUMBERS SAY THEY SHOULD! NUMBERS CAN PERHAPS GIVE US AN IDEA OF

    PROBABILITIES, BUT EVEN AN EVENT WITH AN EXTREMELY LOW PROBABILITY CAN STILL

    HAPPEN, AS WAS THE CASE RECENTLY. AN AWARENESS OF BOTH THE QUANTITATIVE

    AND QUALITATIVE SIDES OF THE MARKET IS IMPORTANT— INVESTING IS NOT PURE

    SCIENCE, IT IS BOTH A SCIENCE AND AN ART.

    Training ONLY not to be used with the public