Why We Do the Things We Do

There was a wonderful article in the Monday, August 24 issue of the Wall Street Journal penned by Meir Statman entitled The Mistakes We Make - and Why We Make Them. The crux of the article was about how investors’ thinking often gets in the way of their investment success.

Today’s blog is the “Cliff Notes” version of the article. We encourage you to read the full article. While the article focuses on investing, it really is about the way we process data. As you read this overview, you may substitute your business, your family or any other activity for ‘investment’. The point of the article is that the mind is a very powerful piece of equipment. The ability to control and harness its incredible power determines success or failure.

Statman begins by posing the question; “How many times have we asked ourselves what was I thinking?”

“…here’s the problem: While we know that we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more important, why they made them. Why did we think and feel and behave as we did? Why did we act in a way that today, in hindsight, seems so obviously stupid? Only by understanding the answer to these questions can we begin to improve our financial future.”

Simply put, our brains are overflowing with emotion. The ability to control this emotion is what determines if we are normally smart or normally stupid. How do we control this situation?

Statman suggests that we need to develop tools. Investors tend to think about each stock they purchase in a vacuum, distinct from other stocks in the portfolio. They are happy to realize ‘paper’ gains in each stock quickly, but procrastinate when it come to realizing losses.

Why do we procrastinate? While we have regrets over a paper loss, we console ourselves in the hope that, in time, the stock will roar back into a gain. This hope would be lost if we actually sold the stock and realized the loss. “So we do pretty much anything to avoid that pain-including holding on to the stock long after we should have sold it.”

Knowing the turbulent waters of the emotional mind Statman offers eight lessons to be learned.

Lesson One: Goldman Sachs is faster than you
“There is an old story about how hikers who encounter a tiger. One says: There is no point in running because the tiger is faster than either of us. The other says: It is not about whether the tiger is faster than either of us. It is about whether I’m faster than you.”

We, as individuals, are not faster than the Goldman Sachses of the investment world. Plan you portfolio for the longer term. Leave the speed to the fast.

Lesson Two: The future is not the past, and hindsight is not foresight (My Favorite)
“The hindsight error leads us to think that we could have seen in foresight what we see only in hindsight.” There are no crystal balls. The only thing we know about hindsight is that is a good evaluator of past events.

Lesson Three: Take the pain of regret today and feel the joy of pride tomorrow
“Stop focusing on blame and regret and yesterday, and start thinking about today and tomorrow.”

Lesson Four: Investment success stories are as misleading as lottery success stories
“We tend to look for evidence that confirms our belief rather than evidence that might refute it.” For example, lottery marketing never talks about the millions of losers, only the few winners. In investing, you will have winners and losers during any period. Focus on the longer term.

Lesson Five: Neither fear nor exuberance are good investment guides

Lesson Six: Wealth makes us happy, but wealth increases make us even happier
Our greatest happiness comes from gains in wealth more than from levels of wealth. Focus on the gain. Frame the positive event. When the average Joe that wins $25 on a scratch-off he is happier than the millionaire whose portfolio went up 1%. “In other words, it’s all relative……Standing next to people who have lost more than you and counting your blessing would not add a penny to your portfolio, but it would remind you that you are not a loser.”

Lesson Seven: I’ve only lost my children’s inheritance
This is a lesson in mental accounting. Mental accounting is a cognitive process that allows us to manipulate our feelings. So here is Statman’s advice: “Ask yourself whether the market damaged your retirement prospect or only deflated your ego. If the market has damaged your retirement prospects, then you’ll have to save more, spend less or retire later. But don’t worry about your ego. In time it will inflate to its former size.’

Lesson Eight: Dollar-cost averaging is not rational, but it is pretty smart
Dollar-cast averaging is a good way to reduce regret and spread risk. Dollar-cost averaging won’t outrun the tiger, but it will distance you from the field. It is not about hindsight, but about foresight. It doesn’t take the pain of investing away, but it does minimize the degree of pain.

As we look back over Mr. Statman’s article, we are reminded that people do stupid things for seemingly rational reasons (emotion). It is our ability to control and harness the mind’s incredible power, however, that determines success or failure.

Steve Cook is the Managing Shareholder of Cook & Associates, PLLC, Certified Public Accountants. The firm offers tax, assurance and business consulting services from its offices in San Antonio and San Marcos, Texas.