The study of behavioral finance has identified many of the cognitive biases that keep investors from making wise financial decisions. Among these are recency bias: the natural human inclination to extrapolate recent events (such as the price increase in a stock) to infinity. Or anchoring bias: the tendency of investors to over-rely on the first fact or conclusion available.
Yet as an investment advisor and financial planner, I’ve learned there’s no bias more deeply ingrained than the inclination to act from instinct at the expense of logic. This is hardly surprising. We are hard-wired to be instinctual creatures. In the Serengeti, it was no help to think about the lion bearing down on you. Better to run first and think second.
When dollars are involved, however, the best advice is often “don’t just do something, stand there.” Acting precipitously, off gut or feeling, nearly always leads to poor financial decisions—especially in investing, where a stock can be sold on impulse with a mere click. A simple example is buying a stock just because it’s gone up in the past with no regard for its underlying intrinsic value—an assessment that can only be made based on the underlying cash flows of the company, and one that could never be made in a paltry instant.
But in the realm of financial planning decisions, I see clients grapple with all manner of emotional derailment. Take, for instance, the common scenario of a client wanting to lend money to a friend. This simple act, motivated by compassion and amity, often leads to disaster and heartache. The problem is so enduring that Shakespeare addressed it in Hamlet: “Neither a borrower nor a lender be; for loan doth oft lose both itself and friend…” In a more contemporary example, Judge Judy tells us that, when lending money to a friend or relative, you should expect to lose a lot more than the interest. She advises just giving a gift of the money you can afford to lose and calling it a day.
A related mistake is to co-sign a loan for a friend or family member. This is never a good idea, because if the person couldn’t get the loan from a bank, there’s often a very good reason: namely, that they are likely to default. When you co-sign a loan, you take on full responsibility for the loan yourself, which can destroy your credit and ruin your financial future. There’s no quicker way to lose a longstanding relationship than to have a co-signed loan go sour. Better, again, to just gift a smaller sum.
I’ve realized the best way an advisor can deliver value is by addressing the emotions that serve to separate clients from their money. A common problem in retirement planning is not allocating enough of the portfolio to stocks at a young age. Often clients come to me in their 30s with large amounts of cash or bonds in their IRAs or 401ks. This makes little sense, given that stocks have beaten the returns on fixed income in every rolling 20-year period going back 150 years. Since retirement accounts are designed to be tapped at age 59 1/2 at the earliest, an investor in their 30s should seldom have any retirement assets in fixed income. Yet the fear of short-term losses and market volatility often keeps young clients on the sidelines. For anyone who knows market history, this is an illogical approach—one where emotions have interfered with facts.
Gut instinct can be a wonderful thing. No doubt many successful businesses have been built on no more than an entrepreneur’s hunch. Split-second decisions are, by definition, the realm of reflex. Anyone who’s avoided a car crash at the last instant can attest to that. But when it comes to finances, it’s best to strip every decision of emotion.