May 23, 2017
May 23, 2017
On October 24th, we are hosting our second annual B|O|S University. The theme for this year’s half day educational event is behavioral finance. We chose this theme based on recent experiences with clients as well as the current market environment. For those unfamiliar, behavioral finance is a relatively new field of study which combines psychology with traditional economic theories to identify the ways in which we predictably make irrational financial decisions. Several recent books including The Undoing Project from author Michael Lewis, who also wrote The Big Short and Liar’s Poker, have added to the field’s familiarity and following. One of the key tenets of behavioral finance is that people make decisions using certain heuristics or mental short cuts and don’t always follow strict logic. At B|O|S, we encounter evidence of these short cuts or biases affecting people’s decision making from time to time. However, as with having something stuck in one’s teeth, these biases are usually more readily noticeable by others than by oneself. This field of study has grown for precisely that reason. Anyone can fall victim to these biases without noticing because they are natural to our instincts. Probably the best way to diagnose our own faulty logic is by developing a basic understanding of some of the more common ways our brains lead us financially astray. Armed with this knowledge, we can hope to be better prepared to avoid the corresponding pitfalls. Below I’ve provided three examples of behavioral biases which I’ve personally either recently or frequently encountered.
While stock prices for some tech firms have soared in recent years, there are many companies that have experienced stock price declines, both big and small. For employees of these not-so-fortunate firms, it is not uncommon to own equity awards granted at prices above current market value. I’ve spoken to a number of people in this situation and have noticed a commonly shared reluctance to sell below the price at which the shares were granted. This is even true when the same people agree that unloading some of their company stock would be the prudent financial thing to do. In behavioral finance, this is an example of anchoring bias. Our brains naturally anchor our view of the stock’s fair value to our acquisition price, even though that price has no bearing on the current fundamentals or value of the company.
Mental accounting concerns our inclination to bucket money into certain categories based on various criteria, such as its source or desired purpose. It can be a helpful behavior when we segregate savings for things like retirement and education, but it can also lead to bad behaviors. Things often go awry when we forget that all assets and liabilities are still part of one balance sheet- ours- regardless of what subjective criteria we may apply to them. Let me give an example. I have a friend who recently received an inheritance from his grandmother. He is very aware that this inheritance has the ability to ease some of life’s financial burdens and he wants to be very diligent about saving, and not spending, the funds. However, in a recent conversation with him, he mentioned he had some credit card debt which he was struggling to pay off. I asked if he had considered using some of his inheritance to pay off the debt and he said he had not. He views his inheritance as his retirement savings and only wants to draw from it in case of emergencies. While this is of course an admirable goal, it is likely not a prudent financial move. The interest rate on his credit card is almost certainly higher- maybe even considerably higher- than what he might expect to earn on his inheritance portfolio. So instead of carrying a credit card balance, he’d be better off using some of his inheritance to pay off the debt now and replenishing those funds if and when he can.
The most dramatic example of wide-spread herd behavior was the dotcom bubble. People were buying technology stocks not because they necessarily thought the underlying businesses were good, but because they thought everyone else was buying them. While stock market valuations are nowhere near the elevated levels seen in the late 1990s, we still encounter investors being affected by herd behavior, especially in hot sectors like technology. We frequently get asked to review the portfolios of prospective clients and we often observe that for Bay Area investors in particular, there is a tendency to own a lot of technology stocks. With these companies in our backyard, we hear a lot about them and the wealth they create for our neighbors, friends and colleagues. No one wants to miss out. The approval of others of course only reinforces our desire to follow along and even when we have doubts, we can easily suppress them. After all, how could so many people be wrong about the same thing? At the risk of stating the obvious, this line of thinking is quite dangerous. If history is any indication, we know there’s real risk to putting all investment eggs in one basket. Just ask Pets.com investors. Following the herd can get us into trouble.
The above-mentioned behavioral biases represent just three of many that have been well-researched and documented. This is an area of study that is growing rapidly and we continue to monitor developments. At B|O|S, we believe these emotional biases are powerful and have the capacity to steer our clients down the wrong path. We see it as our responsibility not only to keep clients on the right track financially, but also to keep them informed on our latest thinking and the latest research in the field. Clients who understand our approach and the reasoning behind it are more likely to stay disciplined when things get tough. There is currently a great deal of uncertainty regarding our economy, the geo-political environment and the stock market. We think understanding ourselves better will help all of us weather whatever storms lie ahead. If you care to learn more about behavioral finance, please save the date for B|O|S University. It will be held at the Omni Hotel in San Francisco on October 24th, and will feature several expert speakers on the topic. More details to come.