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3 Self-Defeating Financial Behaviors

People can make financial decisions that are not in their best interest even when they know they should take a different path.

Michael M. Pompian, 02/22/2013

This month's article is the second in a series called "Building Better Client Relationships by Understanding Investor Types." This series is intended to help advisors create great working relationships with their clients by taking a step back and understanding the type of person they are dealing with (from a financial perspective).

Why is this important? Because individuals process information differently, vary in how they deal with financial decisions, and have different risk preferences, it is essential that advisors interact with each client in a way that is effective. This often means you must change the way you speak to different types of clients, even though your advice may be similar across your client base. Some advisors fail in their tasks not because they don't have technical knowledge of the markets, understand the strategies of investment managers, or have systems that can deliver the best methods of portfolio construction. Rather, they lack an understanding of what is truly important to the client and how to communicate and interact in a meaningful and effective way.

As you know by now, I have dedicated a substantial amount of time promoting the benefits of behavioral finance research and making it accessible to large numbers of financial advisors. In my latest book, "Behavioral Finance and Investor Types," my primary objective was to simplify the practical application of behavioral finance by boiling down many of the complexities involved in diagnosing and treating behavioral biases into a simple concept: "behavioral investor types" or BITs. BITs are defined in large measure by the biases themselves. BITs are categorized in a way that makes intuitive sense and can be easily understood.

Background
As we all know, reaching financial goals can be difficult. We have to work hard for our money in what seems like an increasingly uncertain environment, and delaying gratification is also difficult: When we work hard, we want to enjoy the fruits of our labor. In addition, there are psychological and environmental factors that can impede progress toward meeting financial goals. By understanding some of the psychology behind why people have such difficulties, readers can set the table for applying the lessons we will learn using BITS as we progress through the articles to come in 2013.

In the first two articles of the series, we will look at three financial and two non-financial examples of self-defeating behavior. By doing so, we gain a common understanding of the challenges of controlling behavior and the importance of behavior management. Last month we reviewed some nonfinancial examples of self-defeating behavior; we will now turn to financial examples of behaviors that should be associated with poor investment performance, but yet they are repeated by investors month after month, year after year, cycle after cycle.

Financial Examples of Self-Defeating Behavior
The Return Chaser

One of the most basic of human investing instincts is to be in the know regarding the latest investment trend. How silly we feel when we are at a cocktail party or barbeque and we join a conversation in progress about how your neighbor just made a killing on XYZ stock that participates in ABC hot industry. Why am I not participating in this money-making opportunity, you ask yourself. This occurred with Internet stocks in the late 1990s and then with real estate during the subsequent decade--and we know how those turned out! It may also have recently happened with social-networking companies.

At one time or another we have all seen someone who epitomizes this type of investor--or maybe this is our own behavior! These folks follow the latest trend, paying no attention to valuation. They have no rational basis for making an investment and jump in without an exit strategy, or they plan to get out when a profit has been made, if one is ever made. The investment may go up, but since no plan is in place, the investment ultimately turns sour, and losses ensue. As investors, we must resist the urge to participate in such schemes and steer clear of these money-losing opportunities. Our own behavior is often the culprit, and we need to overcome our natural instincts to participate in less-than-rational investments, or at least we should have an exit strategy if the decision is made to participate.

The Overconfident Gambler
It is not uncommon to come across the type of investor who thinks he is smarter than the average market participant, who enjoys the thrill of trading in and out of the market (like the thrill associated with gambling). Losses may even cause more gambling behaviors to kick in, with the investor engaging in the same risky trading in an attempt to get back to even. This example is in contrast to the person who avoids such behavior  and manages to save and invest over long periods of time to build wealth gradually.

Notice a pattern here? This example is, of course, nearly identical to the yo-yo dieter in the problematic nonfinancial behaviors from last month's article--those who attempt to lose weight quickly on a regular basis only to gain it back. In this case it's the opposite situation: The person attempts to gain wealth quickly, only to "lose it back."

Figure 1 below illustrates the overconfident gambler versus the opposite type of investor, whom I will call the saver-investor. Both start at 25 years old and are currently 50 years old. Figure 1 extends out in time to show that there are still opportunities to change behavior even at mid-life.

Naturally, this chart does not represent reality perfectly, but you get the point: It's not hard to tell which kind of person you want to be. So, why can't we do it? The answer is that we can, but we first need to identify the key factors that are rendering us incapable of engaging in good behavior.

The "Too Conservative" Investor
Although it's not as common, there exists a class of investors who are too conservative in their thinking. They are so afraid of losing money in a down stock market, whether through previous personal experience or not, that they simply won't accept any amount of risk.

The failure with this approach is that people who cannot accept some amount of risk also risk outliving their money. Figure 2 illustrates. Early into one's career, earning may not keep pace with the demand for funds due to expenses like college and housing. At some point during mid-career, these expenses may be surpassed by earnings, and debt is reduced. Then later in life, one's working career can end either voluntarily or not, and cash needs must be surpassed by income. But if one does not accumulate enough of a nest egg and invest it wisely, there can be a situation where one may outlive one's assets.

Certain people in this situation intuitively know that they need to increase risk while they still have the capacity to do so, but they simply cannot take action to do it. They know about concepts such as inflation and low bond yields, but they will not take the risk that is necessary to build wealth. Like the previous figure, this chart does not represent reality perfectly, but again you get the point: You don't want to be in a situation where you don't have enough money as age increases.

We have reviewed three very basic situations in which we have identified a type of investor. The intent was not to go into great detail but to illustrate situations in which it is difficult to control one's impulses toward a certain action or behavior. As we saw with the nonfinancial situations, people often know they are taking actions that are not in their best interest. Similarly in the financial examples, we saw that people can make financial decisions that are not in their best interest even when they know they should take a different path. In many other cases, people may not be aware of their irrational behavior, and they need their advisors to help them understand that they are making mistakes.

In next month's article, we will review an updated categorization of behavioral biases and some key definitions as we progress toward combining the knowledge we have learned so far into the creation of behavioral investor types.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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