Invest with Rules, Not Emotion: A Take from Behavioral Finance
By: Hatem Dhiab
In 2017, the Nobel prize for economics was awarded to Richard Thaler for his work upending the longstanding notion that individuals make rational decisions about their futures and finances. His work helped develop policies intended to nudge people toward altering their choices, such as automatic enrollment into 401-k plans and automatic savings increases.
This award highlighted the decades-long rise of behavioral economics from the profession’s margins to its center. Thaler’s strain of research came to prominence in the 1980s and 1990s and challenged the popular view in economics that individual decision-making was rational, predictable and easily modeled. Mr. Thaler didn’t see that in everyday life.
Thaler built his work on contributions from friends and mentors, the Israeli psychologists Amos Tversky, who died in 1996, and Daniel Kahneman, who won the 2002 Nobel Prize. They were part of a broader counterrevolution against the notion that markets are best left to their own devices.
As financial planners and investment advisers, there’s a lot to learn from the fields of behavioral economics and psychology. We must be knowledgeable on many areas of planning but also acknowledge the limitations of our understanding of greater and more complex themes. We also need to be more attentive rather than conclusive so we can provide appropriate advice while helping our clients focus on the most important outcome, their goals.
There’s many distractions along the way that will prevent people from making the right financial decisions; overcoming those distractions is the ultimate goal. Markets will provide the tools to get to our goals but shouldn’t be the drivers. We also need to understand that our clients will also fall victims to those same heuristics and biases. If we are able to help them identify myth from fact and instill the correct behaviors--ones that promote discipline, focus and process--then we are assured to succeed.
As investors, we have to also be mindful of these same biases. As a result, when discussing and picking companies to invest in, our process at GK has safeguards built in to allow us to recognize the traps of the mind. As an example, to deal with confirmation bias, we don’t rely on our intuition and routine thinking for ideas, but we rather slow down and get analytical about our investment decisions. Often it takes weeks or months before delving into an investment. Admitting our mistakes and changing course are also important if new information comes to light: we’re not always right, and we are OK with that. Not predicting the unpredictable and striving to be as rational as possible are also ways to deal with our behavioral shortcomings.
Lastly, having rules is very important to success. Putting money to work every single month, for example, regardless of what the market appears to be doing at that particular moment, has proven to be a smart technique. Focusing on the long term and tuning out short term fluctuations and market noise is also critical to success.
Markets are irrational, people are emotional, but if we apply ourselves and have a well thought out plan, then we are less likely to succumb to the pitfalls of our human fallacies.
It’s worth the mention that Tversky and Kahneman’s lives and work were brilliantly outlined in the recently published must-read book by Michael Lewis, The Undoing Project. The two psychologists devoted their lives to understanding how humans make decisions, how we judge and predict outcomes, and how to better understand and counteract the biases that drive us. Their work will go on to change most fields—from medicine, finance, public policy, economics and beyond.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Gerber Kawasaki Inc, a registered investment advisor and separate entity from LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.
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