Logical Thinking and Behavioral Finance. SRI in the Rockies October 19, 2002 Johann A. Klaassen, Ph.D. Logical Thinking and Behavioral Finance.
SRI in the Rockies
October 19, 2002
Johann A. Klaassen, Ph.D.
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 …
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”.
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.
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.’
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 118