Don’t trust your gut (in financial planning)
The study of behavioral finance has identified many cognitive biases that prevent investors from making sound financial decisions. Among these are recency bias: the natural inclination of man to extrapolate to infinity recent events (such as the increase in the price of a share). Or anchor bias: the tendency of investors to rely too much on the first fact or the first available conclusion.
Yet, as an investment advisor and financial planner, I have learned that there is no more ingrained prejudice than the tendency to act on instinct at the expense of logic. This is hardly surprising. We are programmed to be instinctive creatures. In the Serengeti, there was no point in thinking of the lion swooping down on you. Better to run first and think second.
However, when dollars are at stake, often the best advice is “don’t just do something, stay there”. Acting in a rush, out of instinct or sentiment, almost always leads to bad financial decisions, especially when it comes to investing, where a stock can be sold on impulse with a single click. A simple example is buying a stock simply because it has risen in the past without considering its underlying intrinsic value – a valuation that can only be made on the basis of the underlying cash flows. of the business, and which could never be done in a paltry moment.
But in the realm of financial planning decisions, I see clients going through all kinds of emotional derailments. Take, for example, the common scenario of a customer wanting to lend money to a friend. This simple act, motivated by compassion and friendship, often leads to disaster and grief. The problem is so persistent that Shakespeare addressed it in Hamlet: “Neither borrower nor lender is; because the loan does not lose both himself and a friend… ”In a more contemporary example, Judge Judy tells us that when you lend money to a friend or relative, you should expect lose much more than interest. She advises giving the money you can afford to lose as a gift and calling it a day.
A related mistake is co-signing a loan for a friend or family member. This is never a good idea, because if the person was unable to get the loan from a bank, there is often a very good reason: and that is, they are likely to default. When you co-sign a loan, you take full responsibility for the loan yourself, which can destroy your credit and ruin your financial future. There is no faster way to lose a long-standing relationship than to have a co-signed loan that goes wrong. Better, again, to offer a smaller amount.
I realized that the best way for an advisor to create value is to deal with the emotions that serve to separate clients from their money. A common problem in retirement planning is not allocating enough portfolio to stocks at a young age. Often times clients come to me in their thirties with large amounts of money or bonds in their IRAs or 401ks. This does not make sense, given that stocks have beaten fixed income yields in every rolling 20-year period for the past 150 years. Since retirement accounts are designed to be operated at age 59 1/2 at the earliest, an investor in their 30s should rarely have fixed income retirement assets. Yet fear of short-term losses and market volatility often keep young clients away. For anyone familiar with the history of the market, this is an illogical approach, one where emotions have interfered with facts.
The gut instinct can be a wonderful thing. There is no doubt that many successful businesses were only built on the intuition of an entrepreneur. Split-second decisions are, by definition, the domain of the reflex. Anyone who avoided a car accident at the last moment can attest to this. But when it comes to finances, it’s best to suppress every emotional decision.