• Managing the best of two worlds
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     | November 25,2013
     

    The proverbial “they” say that we are what we eat. I’ve been wondering if the same applies to investing. Are we what we choose to invest in? If we are skydivers by day, are we stock traders with a wheeler-dealer Vegas mentality by day? And if we don’t drive when there’s snow on the road and it’s dark outside, do we only invest in short-term bonds and CDs?

    I recently read a book about behavioral finance that had been recommended to me by a colleague. Behavioral finance is often overlooked by investment professionals and yet, it’s really critical to understand this branch of investing.

    This area of study is tricky because it’s important to understand that investors, who are people like you and me, are not one extreme or the other. We are not computer-like, disciplined and rational 100 percent of the time; likewise, we are not bumbling, crazed and irrational most of the time either.

    The author of What Investors Really Want, Mier Statman, a professor of behavioral finance at Santa Clara University, notes that most investors are “often normal-smart but sometimes normal-stupid.” (I won’t speak for you; I guess I can say that about just about everything we do in life but this column is about investing.)

    Statman feels it is important to understand what normal investors really want. He opines that if we can’t understand who we really are as investors, we can’t help ourselves. Similarly if financial advisors can’t understand what normal investors really want, they too can’t help. Statman feels that normal investors want more from their investments than profits equal to risks. He says, “we want to nurture hope for riches and banish fear of poverty. We want to beat the market, to feel pride when we make money and avoid regret when we lose.” In short, we want the best of both worlds. We want to spend money when we have it but save for tomorrow and build retirement savings without the pain of not having the money today.

    Perhaps it’s OK for a PhD in finance to say that people make stupid financial decisions as long as they put themselves in the same camp. Statman notes that he’s made more than his share of bad money decisions. He notes that normal investors need to be protected from themselves. By that, he means that given our lack of investing intelligence, all American employers should be required to set up retirement plans for their employees, and all employees should be required to contribute. No choices. This would protect the wheeler-dealer investor and the never-invest-in-anything-but-CDs investor from their own folly: being too aggressive and being too overly conservative.

    He advocates for every employee to have a defined contribution plan (like a 401k) and investing in index mutual funds, like a fund that essentially mimics the Standard and Poors 500 or some other index. Indices are usually broadly diversified and over time, they tend to perform better than bonds and money market funds but not better than some individual stocks, although they aren’t as risky either.

    I won’t argue with the notion that we should all have a mandatory savings account outside of Social Security, but I doubt that is coming down the pike anytime soon by order of the federal government.

    There are ways to do this for yourself and when you retire, you will be better off because of it. Disciplined investing can only be done if your human hands don’t touch the money. Your son needs a new fill-in-the-blank this week, you need another XYZ at home, you want to go on vacation this summer. You can still do all this, but it means living within your means minus the money you earned but never saw. That money that socked away for retirement.

    Much as we may not want to admit it, we all know ourselves. We all know if we are capable of sticking to a diet or being a disciplined saver. For most of us, we can have willpower. Up to a point. If you are going to be a strong investor, have the will to take the power away from yourself. If we all did this, maybe a normal investor would be normal-smart most of the time and the other-normal hardly at all.



    Karen Paul is a financial services consultant in Burlington.

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