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By Christine Benz | 01-11-2012 02:00 PM

Anchors Away From Your Portfolio Plan

If someone hypothetically sold everything in your portfolio today and you woke up tomorrow with cash, would you reinvest it the same way?

Christine Benz: Hi, I'm Christine Benz from Morningstar.com.

Investors often behave in ways that run counter to their own interests. Carl Richards, a financial planner, a blogger for The New York Times and a contributor to MorningstarAdvisor.com, has written new book that addresses this tendency, and it's called The Behavior Gap. He is joining me via Skype to talk about it today.

Carl, you've got a great sketch in the book, and I think it comes back to this idea of what a lot of behavioral economists call "anchoring." So let's talk about what that is, and also to the extent that you can offer some concrete ideas for investors to combat that tendency to anchor on what's going on in the present period of time.

Carl Richards: The idea behind anchoring, we all do this, and it's really easy, at least recently it's been, with real estate. We tend to get focused on a price, and it's often either the price we bought an asset at. We could talk about an individual stock; let’s say that you paid $50. That’s the example I use this sketch. You paid $50 for XYZ stock, or you put $5,000 into a specific mutual fund, and now it's only worth $30; the stock has gone from $50 to $30.

There is this tendency for us to feel like, "if it just gets back to $50, I'll sell it. I  made a mistake," because we don’t want to realize the loss. Selling it is actually the physical act that represents recognizing a loss, recognizing a mistake--I made a mistake--and so as long as we don't sell it, we can still pretend like maybe we didn’t make a mistake.

So we anchor on this $50, and I hear people say this all time, "I'll just sell that when it gets back where I bought it." The thing we have to realize, and it is the same with real estate, if you're trying to sell a rental property or your own residence, and you paid $200,000 for the place and it's only worth $150,000, nobody cares that you paid $200,000. The market, and back to the stock example, nobody cares if you paid $50 and it's trading for $30. Nobody cares--the market doesn’t care. The market doesn’t care.

Benz: The stock doesn’t know it was once $50.

Richards: The stock doesn’t know, and nobody else in the market cares what you paid for it. All they care for is what’s the value today. ... And I think we do this investments a lot; we think, "I inherited this from grandmother." We have these are emotional reasons, sometimes it’s anchoring, sometimes it's other emotional reasons that we hold on to investments, and we end up with this sort of collection, almost like a smorgasbord; instead of a portfolio, we have this sort of collection that, "I bought that back here, and I bought this here, and I haven't sold it." Sometimes they represent skeletons in the closet.

I think one really helpful thing is what I call the overnight test, and it’s just to take your portfolio--and I think it’s helpful to do this once a year--I don’t think you should be making these changes, but ask yourself this question: "If somebody sold everything in my portfolio today"--and again, this is totally hypothetical, don’t worry about taxes, don’t worry about commissions or fees, just hypothetically, if somebody sold everything in your portfolio today and you woke up tomorrow with cash, would you reinvest it the same way?

Almost universally when I ask that question, people say "no." I know that XYZ stock was a mistake or it's not appropriate for my portfolio or just because my grandmother owned it and I inherited it from her doesn’t make it right for me, but there are these emotional reasons.

So once you've had that discussion, and said no I wouldn’t reinvest it the same way, then you can get to work on the practical application of that information: What are the tax implications and how would you reinvest it? But I think it's helpful to at least start the conversation about, am I holding on to these things for emotional reasons that no longer make sense?

Benz: Carl, you also were forthright. You shared an example about your own experiences with real estate. Is that something that you think exemplifies this concept of anchoring?

Richards: Anchoring could have been a problem. I think the other problem at least with my own experience, we made some mistakes in our real estate decisions. We happen to live in Las Vegas. So the mistakes were amplified, because the market was so wild, and I think what you're referring to is, I wrote about it pretty publicly in the New York Times, and one of the mistakes we made, which there is a sketch earlier on in the book, is we projected the recent past and this is ... we just ... humans do this. We take the recent past, and we project into the future forever.

When real estate in Las Vegas was going up, and my income was growing and everything was great, it was very easy to say, "oh, this will continue." And we do this with the equity markets.

When things are bad, people say "It's going to bad forever; it's never going to change." We've got to remember, things change, and projecting the recent past into the future is a very, very dangerous game, and that’s what happened. That’s one of the classic mistakes we made.

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