MarketPsych E-Book

Richard L. Peterson

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 374

Veröffentlichungsjahr: 2010

Beschreibung

An investor's guide to understanding the most elusive (yet most important) aspect of successful investing - yourself. Why is it that the investing performance of so many smart people reliably and predictably falls short? The answer is not that they know too little about the markets. In fact, they know too little about themselves. Combining the latest findings from the academic fields of behavioral finance and experimental psychology with the down-and-dirty real-world wisdom of successful investors, Drs. Richard Peterson and Frank Murtha guide both new and experienced investors through the psychological learning process necessary to achieve their financial goals. In an easy and entertaining style that masks the book's scientific rigor, the authors make complex scientific insights readily understandable and actionable, shattering a number of investing myths along the way. You will gain understanding of your true investing motivations, learn to avoid the unseen forces that subvert your performance, and build your investor identity - the foundation for long-lasting investing success. Replete with humorous games, insightful self-assessments, entertaining exercises, and concrete planning tools, this book goes beyond mere education. MarketPsych: How to Manage Fear and Build Your Investor Identity functions as a psychological outfitter for your unique investing journey, providing the tools, training and equipment to help you navigate the right paths, stay on them, and see your journey through to success.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

Acknowledgments

CHAPTER 1 - Your Investor Identity: And Why You Need One

Psychology and Finance: Failure to Communicate

Beginning the Journey

Risky Business

Resisting Your “Idiot Friend”

Finding Your Investor Identity

CHAPTER 2 - Investor Identity Fundamentals: Frames, Motivations, and Goals

The Detail-Orientation Test: A Case Study in Frames

Frames: Your Tinted Glasses

Motivations: The Iceberg Theory

Goals: Create a Slide Show to Guide Your Investing

The Five Questions to Ask Before Investing

Conclusion

CHAPTER 3 - Your Investor Personality: Your Character and Style

What Makes a Great Investor?

The “Big Five”

The Character of Performance

Working with Your Traits

The Genetics of Successful Investing

Using What You’ve Learned

Conclusion

CHAPTER 4 - Your Investor Emotions: The Hidden Drivers of Behavior

Restless Ed, the Redemption-Seeking Channel Trader

Financial Wounds and Emotional Wounds

Understanding the Science behind Emotion

Using Your Emotions for Good: Damasio and the Iowa Gambling Task

Stirring the Unconscious

Being Triggered

Name That Emotion

Emotional Defenses

Ed’s Epitaph

Conclusion

CHAPTER 5 - Your Investor Values: What’s Most Important to You?

Enjoying the Process

The Financial Values Questionnaire

Values Leakage

The Impact of Financial Traumas

All in the Family

George Kinder and the Three Questions

Digging into Money Taboos

Conclusion

CHAPTER 6 - Your Investor Blind Spots: Identifying (and Avoiding) Mental Traps

Trap #1: Win/Lose Mentality

Trap #2: Down with the Ship Syndrome

Trap #3: Anchoring

Trap #4: Mean Reversion Bias

Trap #5: Endowment Effect

Trap #6: Media Hype Effect

Trap #7: Short-Termism

Trap #8: Overconfidence

Trap #9: Herding

Trap #10: Hindsight Bias

MarketPsych’s Investing Traps Worksheet

Conclusion

CHAPTER 7 - Your Investor Stress: Smoothing Out the Ups and Downs

Stress: An Overview

Physical Effects of Stress

Choking

Managing Short-Term Investment Stress

Cognitive-Behavioral Techniques for Long-Term Stress Management

Financial Stress Management Plan (F-SMaP™)

Conclusion

CHAPTER 8 - Being Your Best Self

Psychological Foundations

Brain Boosting

The Economics of Behavior Change

Learning Optimism

Committing to Your Peak Performance Routine

Setting up Goals

Conclusion

APPENDIX A - Summary of Meditation Techniques

APPENDIX B - Gratitude List

Notes

About the Authors

Index

Copyright © 2010 by Richard L. Peterson and Frank F. Murtha. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Peterson, Richard L., 1972-

MarketPsych : how to manage fear and build your investor identity/Richard L. Peterson, Frank F. Murtha.

p. cm.

Includes index.

ISBN 978-0-470-54358-0 (cloth); 978-0-470-88677-9 (ebk); 978-0-470-88664-9 (ebk)

1. Investment advisors—Psychology. 2. Investments—Psychological aspects. 3. Stockbrokers—Psychology. 4. Financial planners—Psychology. I. Murtha, Frank F., 1970- II. Title.

HG4621.P468 2010

332.601’9—dc22 2010013523

For Sarah, Lucia, and Aurora. You are such a joy!

—Richard

For Lillian. Thanks for keeping me on the path.

—Frank

Preface

You may not realize it but you are on a dangerous journey—the life-long process of wealth accumulation. Your destination is to establish financial freedom and security so that you (and your loved ones) can enjoy the quality of life you have always wanted. But make no mistake, you have an enemy that doesn’t want you to get there. The enemy is “the market,” and it is engaged in a covert psychological war designed to subvert you at every opportunity. The market probes for emotional weak spots and exploits them, scaring you out when the worst is over, luring you in when the gains have been made, baiting you into chasing fool’s gold, or convincing you to it ’s okay to perpetually “start tomorrow.”

Sure, the journey seems easy enough. Buy low, sell high, and all that. The market goes up over time. Just put your money away, and you’ll get to where you want to go. If only it were that easy. Investing in the market more closely resembles a crooked carnival game in which you throw a softball at a stack of milk bottles for a dollar. “It’s so easy! So simple, a child could do it. Step right up!” The deception is the simplicity. The game is designed for you to lose.

Don’t believe us? From 1989 through 2008, the S&P 500 Index had a 5.51 percent average annual return after inflation. Looks fine, you say. But what did the average equities investor get as an average annual return, postinflation, during that same 20-year period? Negative 0.97 percent per year. (We told you the market was out to get you.) Those are percentages. What about real-life dollars?

A “market” return on $100,000 invested in the U.S. stock market in January of 1989 would yield a postinflation total of $292,329 20 years later—nearly three times as much. Yet the average equities investor would have a total of $82,288 after the same time period. These two returns represent the difference between Ivy League universities for your kids or state schools, between a down payment on a house or not, between vacationing or staying home. In short, this is the difference between leading the life you want to live, and leading the life you’re forced to live.

Losses are not only possible, they’re predictable. It’s the way the game is designed. At the carnival, they get you with physics—the milk bottles are spread out so that it is virtually impossible for a softball to knock them all down with one throw. The market gets you with psychology, baiting you into a reactive paradigm that turns your own fear, greed, hope, and even pride against you. After several go-rounds we find ourselves asking, where’s my 9 percent average annual return? And how come I never knock down all the milk bottles?

The investing process even preys on our own biology. The rational, reasoning part of our brain—the prefrontal cortex—evolved about 100,000 years ago. It grew on top of the deep brain centers that manage emotion and motivation (the limbic system). In general, the evolution of the prefrontal cortex is an excellent thing—it’s essentially what makes us “human.” The problem is that the prefrontal cortex evolved after the limbic system, and thus while it sits on top of the limbic system and manages and directs our impulses, it can be knocked offline by surges of emotion courtesy of you-know-who.

That is why we wrote this book: to destroy this myth, reset the rules of the game, and to arm and train you for the psychological battle. It all starts with the recognition of a truth that we call the fundamental premise: Investing success appears to be about “the market,” but it’s not; it’s about you. The market will do what it has always done—go up, go down, and try to throw you off like a rider on a mechanical bull. The only question that matters is, what will you do? Here is where our focus needs to be, on what we can control. And this book outlines what those things are and what it takes to master them.

We know that some of the concepts along the way may be counterintuitive. That’s why everything in this book is backed up by scientific research in the fields of neuroscience, behavioral finance, and clinical psychology.

Who is this book for? It’s for you. You have hopes and desires for a better life for you and the people you care about. And you invest your money—or should—so that you can achieve this better life. Whether you are a first-time investor who is just beginning the process or a seasoned professional looking to optimize performance, the key to success remains the same—managing emotions and establishing what we call an investor identity. This book serves as a guide for doing just that. It uses a number of different techniques including case studies, exercises, and questionnaires/self-assessments along the way so you can relate these concepts specifically to yourself and begin building the skills to use them.

Chapter 1 gives an overview of the relationship between psychology and investing and provides a context for the book. It also introduces the concept of an investor identity and why it is crucial for long-term investing success.

Chapter 2 lays out the fundamentals of an investor identity. It addresses where to start (what we call frames), and the five questions to ask before investing. Unfortunately, in taking these “first steps” many investors start out on the wrong foot, ensuring problems ahead. The chapter goes on to uncover the real and hidden motivations that underlie our investing decisions, another crucial component of your investor identity. The chapter concludes with a section on goal-setting, outlining a technique we call the Slide Show Method that keeps investors focused on what they want their investing to achieve.

Chapter 3 digs into the concept of your investor personality. It breaks your particular personality down into the “Big Five” traits associated with both investing success and vulnerability. It details how you can identify these traits in yourself and work with them. This chapter also addresses the genetic components that contribute to your investing style.

Chapter 4 is about recognizing the role emotions play in your investing decisions. Most people recognize that investing is an emotional process. What they often fail to appreciate is the extent to which these emotions are hidden, even from ourselves. This chapter addresses how these unconscious emotions often subvert our attempts to make good choices with our money—and what we can do to gain control over them.

Chapter 5 addresses your investing values. In particular, it goes into the root causes of the what, how, and why of your biggest investment beliefs and the ways they affect your choices—for good or ill. This chapter also helps you identify ways you can play to your investing strengths by investing in a way that is in keeping with your values and interests. Last, it addresses financial traumas and what they do to our investing identity going forward.

Chapter 6 addresses your blind spots. It details a number of the most common (and nastiest) traps and how and why investors fall into them. This chapter also contains checklists so you can evaluate your personal susceptibility to these problems and outlines steps you can use to free yourself and avoid them in the future. It concludes with a set of investing archetypes based on recognizable characters.

Chapter 7 addresses the ways in which investing stress takes its toll on your decisions and what you can do to prevent its negative consequences. In particular, it focuses on biological and psychological elements, detailing specific techniques you can use to ameliorate the effects of stress. Subjects include breaking out of slumps, cultivating resilience, and creating internal dialogues to improve performance. The chapter concludes with a method we call the Financial Stress Management Plan and a guide of how you can create one for your investing process.

Chapter 8 pulls it all together. Now that you have a stronger sense of your investor identity, this chapter details how you can preserve that identity, operate as your “best self,” and create the optimal environment for success. This chapter details a holistic approach to keep you up and running at maximum efficiency.

Lastly, we strongly encourage all readers to complete a free Investor’s Personality Test at www.marketpsych.com/personality_test.php. This test identifies strengths and vulnerabilities in personal investing.

It may feel like the market doesn’t want you to reach your rightful destination. Well, we do. Consider MarketPsych: How to Manage Fear and Build Your Investor Identity to be your personal travel guide on your investing journey. And while we can’t guarantee that you will become rich from reading this book, we can guarantee this—if you read this book and do the work contained herein, you will be part of a select group of investors equipped with the essential psychological tools that lead to great performance.

And the next time the market tries to wage psychological war on your future—it’ll be a fair fight.

Acknowledgments

Thomas Samuels—your insights, laughs, and keen observations are woven throughout this book. Thank you for being a mentor and friend.

Richard Friesen (MarketPsych Director of Trader Training), we appreciate your wit, wisdom, and enthusiasm. Mark Harbour, wealth advisor extraordinaire and president of the Applied Behavioral Finance Group of the Los Angeles CFA Society, thank you for your invaluable assistance and inspiration in this project (no doubt entirely instigated by Bernadette).

We are indebted to the work of Joe Jabaly and Susie Gharib at Nightly Business Report and Bob Frick at Kiplinger’s for their help in publicizing recent advances in the science of investment psychology. Thank you for providing this invaluable service to the public. We’re grateful for the formative insights of Fred Pinto with the Toronto CFA Society and Steve Horan with the CFA Institute. They have provided excellent feedback and encouragement as we’ve developed applied tools for financial advisors.

We appreciate the enjoyable conversations with Doug Lennick at Lennick Aberman Group and his wonderful insights into the psychological pressures of wealth management.

We’d like to acknowledge the wonderful people at Guardian Investor Services with whom we’ve worked closely throughout the years. In particular, the crew who coordinate the events, namely Mr. Kim Boriin, Brian Brown, and Jodi Ieva. They are true pros, and we will always owe them a debt of gratitude (and in the case of Brian, a pint of Guinness). Also a special thank you to the many professionals with whom we have worked, including, but not limited to, Peter Kalianosis, Brian Kravitzski, Clint Kruse, Jim Lake, Marco Molea, Mike Rowe, Greg Rusteberg, and many others. Many of them are Red Sox fans, but they’re still good people. A special thanks to Sarah Awan Johnson and Frank Marino, who gave us our first chance to put these ideas into action. Their ability to see the value in this work long before others and take a chance on it will always be appreciated.

We’d also like to acknowledge the fine folks at Brandes Investment Partners, in particular Leah Brock, Pascal Boisvert, Matt Brundage, and CEO Oliver Murray. They are always involved in creative and cutting-edge ways of applying behavioral finance. In addition to wonderful business partners, they are simply delightful company, and you couldn’t ask for a better bunch to go to a Blue Jays game with.

We appreciate the assistance of Bob Seaberg at Morgan Stanley Smith Barney, who provided invaluable opportunities to interact and share insights with his global network of wealth advisors. Jennifer Gabriele at Morgan Stanley Smith Barney shared her insight into the daily challenges of advisors. We’re grateful to Jan Sparrow and Scott Asalone for their perceptive and enriching thoughts on working with emotional investors. They continue their wonderful work through the Greatness Project at greatnessproject .com. We are greatly appreciative of the opportunity to work with some of the top financial advisors in the country at Merrill Lynch Global Wealth Management. Thank you Anna Callori and Rosanna Innes!

We’re indebted to the encouragement and good cheer of Alexis Zonfrilli and the kindness and support of Alison Hill at Goldman Sachs. Alison and Alexis went out of their way to support our creative efforts.

We’re grateful to Aishwarya Shan and Sharon Liew at Marcus Evans Kuala Lumpur for the opportunities to interact with and learn from private bankers and wealth managers in Asia. We’ve greatly enjoyed the relationships and friendships that have developed from these annual workshops in Seoul, Singapore, Mumbai, and Sydney. It goes without saying that the past decade has been incredibly tumultuous for investors. We thank those who generously shared their stories, their struggles, and their successes with us, including hundreds of financial advisors and portfolio managers around the world. You are too numerous to name, but without your stories and inspiration this book could not have been written.

We owe a debt to the many scientists and researchers who have advanced the sciences of psychology, experimental economics, behavior change, and neuroscience (all together we will call them neuroeconomics or neurofinance). In particular, we are indebted to the work of Paul Zak, James Montier, Michael Mauboussin, Brian Knutson, Camelia Kuhnen, Colin Camerer, Greg Berns, and John Coates.

And on a personal note, Frank would like to thank his wife, Lillian, for being a major source of support and encouragement during the process; his brother, Loring, for selflessly offering logistical support; and his mom for driving down from New Hampshire to clear up time for him to write, even if it was largely an excuse to see her baby grandson. Frank would also like to thank Rob Crystal and David Berdon, two insightful investing professionals, but more importantly two good friends willing to endure geeky conversations about the market so that he could write a better book. He is grateful to you all.

Richard adores his wife, Sarah, who is his inspiration. Frank sends thanks to the guys (and Georgia!) at Shoreline Trading for putting up with his endless questions and observations about the markets and his intractable accounting illiteracy. Also thanks to the endurance of his colleagues at MarketPsy Capital—Yury Shatz, Thomas Hartman, Jacob Sisk, Ali Arik, and Justin Chan who have traded and profited from market panic with him. They are good friends and co-creators of the novel and quite profitable way of forecasting investor and market behavior.

CHAPTER 1

Your Investor Identity: And Why You Need One

The unexplored area is the emotional area. All the charts and breadth indicators and technical palaver are statisticians’ attempts to describe an emotional state.

—Edward Johnson, founder of Fidelity Investments

These words were spoken by Edward Johnson more than 40 years ago, and they ring every bit as true today. So why, after so much time, is the psychological understanding of investing decisions still so widely misunderstood? Given the volatility of the past decade, it stands to reason that merging the lessons of psychology and finance could be wonderfully beneficial to investors.

Psychology and Finance: Failure to Communicate

It’s not that I can’t help these people. It’s just I don’t want to.

—Tom Hanks, Volunteers

The movie Volunteers is an immensely underrated comedy starring Tom Hanks and the late John Candy. In an effort to avoid a gambling debt, Hanks’s character poses as a Peace Corps volunteer and boards a plane to a developing country. Shortly after arriving, he seeks to return home. When an incredulous Peace Corps organizer pleads with him to stay by entreating him, “But you can help these people!”, Hanks responds with the classic line quoted above.

This quote is also a fair way to think of the relationship between psychology and finance. These two fields have lived side by side in the same neighborhood for more than a hundred years and have never been properly introduced.

Traditionally the world of psychology has not only been uninterested in finance, but often disdainful of it. There are a number of possible reasons for this disconnection, but one may stem from the fact that the world of finance is full of guys who played on the football team and the world of psychology is made up largely of kids from the drama/science/glee clubs. Of course the primary goals for each profession are different, and that contributes to the problem. But the jock/nerd dynamic is still there.

This is unfortunate because the field of psychology has much to offer the investing world. Few things are as emotional (or stressful) to people as their money. Money is the number one issue mentioned both as a cause of divorce and an instigator of sleepless nights. It is at the heart of what we call “quality of life.” Simply to help individuals invest more effectively and build greater wealth is to make a huge positive impact on their lives.

It has long been accepted that psychology affects investing decisions. Yet scientific inquiries into how it does so are a recent phenomenon. Part of the reason for this inability to connect may be due to the complicated nature of the task; quantifying human thought and behavior is notoriously messy.

But that’s no excuse. The field of psychology has done a poor job of presenting its insights to the financial community in a way it can relate to. Much of the misunderstanding between psychology and finance is due to the language barrier. “Psychobabble”—which has led to such dreadful sentences as “I want to process your affect” and “Let’s reframe your cognitive schema”—not only puts up a wall to financial professionals, it annoys them.

To this day in the work we do, we encounter antiquated stereotypes freely voiced or lying just below the surface. For some reason, there is a popular image of psychologists as being older gentlemen who wear earth-tone sweaters, smoke pipes, and periodically stroke their beards, asking questions like, “And how does that make you feel ?”

Psychologists aren’t altogether to blame for this sour relationship. Financial professionals have been trained to pay so much attention to numbers that they have become utterly mistrustful of fields that focus on words: Can’t graph it? Can’t express it in an equation? Then it’s touchy-feely voodoo.

Fortunately, rigorous scientific disciplines have emerged in the study of decision-making. The goal of applied psychology today, particularly for those in the counseling and consulting fields, is to help clients develop better habits for going about their business—that is, to make people more effective at what they do—and that includes investing. As such, applied psychology and decision science are uniquely situated to help the individual investor.

Think of investing as a journey. There is a path you walk down and a destination you are trying to reach. The first steps ought to be the most carefully considered. The earlier you misstep, the farther and more quickly you wander off the path. Yet these first steps are the ones that are most likely to be taken in haste and carelessness. All too often investors plunge ahead to find they have not only wandered off their path, but perhaps chosen the wrong path entirely, or maybe even targeted a destination they will never reach. These initial missteps are most often caused by fundamental flaws in the investors’ psychological framework. Beginning with the proper mental approach is essential. Psychologists can help.

Beginning the Journey

Let’s turn to Edward Johnson again:

What is it the good managers have? It’s a kind of locked in concentration, an intuition, a feel, nothing that can be schooled. The first thing you have to know is yourself.

His words were referring to professional money managers, but his wisdom is universal; one has to understand oneself in order to be successful as an investor.

However, Johnson was not entirely correct about one thing. The lack of self-knowledge among most investment managers is not due to the fact that it cannot be learned (e.g., in business classes, training, etc.). The problem is that such characteristics have never been properly taught. With all due respect to Mr. Johnson, although self-knowledge can’t be memorized from a book, skills for developing self-knowledge can be acquired.

The most cohesive attempt to integrate psychology and investing is a field called behavioral finance. This field made its name by demonstrating that traditional economics is based on a false assumption—that human decision making is typically rational, profit-maximizing, and self-interested. Dr. Daniel Kahneman, a psychologist who shared the Nobel Prize for Economics in 2002, won the prize for his research with Amos Tversky demonstrating that financial decisions are systematically biased in non-rational ways.

For all the great research done in behavioral finance identifying irrational investing behavior, the field has had trouble progressing beyond the realm of “investing parlor tricks,” pointing out strange and quirky mistakes investors are prone to make. The findings are interesting, but what doyou do with them?

While researchers in behavioral finance have identified systematic investor mistakes, they tend to offer these findings as solutions unto themselves, as if to say: “We’ve determined that investors fail to make rational and self-interested decisions. So, now that we established this fact . . . go forth and make rational, self-interested decisions!” [There are some notable exceptions, and one that comes to mind is the Save More for Tomorrow Plan (SMaRT Plan) devised by Shlomo Benartzi and Richard Thaler.]

Stopping at identifying mistakes would be enough, of course, if knowledge equaled change. (“You say this is bad for me? Great. I’ll stop doing it, then.”) But knowledge does not equal change. If it did, the world would be a different place. For starters, kids would eat their vegetables. Teenagers wouldn’t smoke cigarettes. And stock market investors would average roughly 10 percent returns annually.

Knowing what to do is only a first step toward success—a necessary but insufficient condition for change. You do not lose money with your mind. You lose money with your actions—namely, buy, sell, and hold decisions that work out poorly.

If the problem isn’t a lack of knowing (and it isn’t), neither is the problem a lack of caring. Most people don’t want to make decisions that are bad for them (Freudian notions of self-sabotage be damned!). And yet most investors not only make irrational decisions, they persistently and reliably make such decisions. Investors, generally speaking, know what to do and want to do it. The problem is . . . they can’t bring themselves to do it when they need to.

It may be useful to think of investing mistakes in terms of an epidemic currently afflicting the United States. Americans have a higher percentage of citizens who are overweight than any other country. We are, simply put, the fattest nation on the planet.

Barring the rare cases of metabolic disorders, the best way to avoid weight problems is to eat a healthy diet and exercise regularly. Everyone knows this—children as well as adults. Every school district in the country drills this message into its students starting in grade school. And it doesn’t take long for most people to recognize that the extent to which a food is bad for you is directly correlated with how good it tastes. So a lack of knowledge is not the problem.

The problem isn’t even that people don’t care about being overweight. The United States has an astounding number of joggers and gym-goers relative to its peers. Moreover, we are constantly being inundated with idealized body images in the media (thin for women, buff for men). We do care. We may even care too much. These unrealistic body images are widely blamed for the relatively high rate of eating disorders and steroid abuse in the country.

Nor is there any shortage of advice on ways to help remedy the problem of obesity. If you wanted to lose weight, you could go to the health and nutrition section of any major bookstore and find shelves upon shelves of books with detailed dieting programs. Moreover, most of those programs would work. But that utterly misses the point.

The question remains: What is the right plan for you? The right plan for you isn’t the one that “would work if you follow it.” (All those plans work if you follow them!) The right plan for you is the one you can best follow. In other words, the plan for you is one that is most suited to your preferences, values, beliefs, and emotional strengths and weaknesses. This book does not recommend a specific method of investing. There are many right ways for people to invest their money. Choosing one is primarily a matter of fit.

It’s important to remember that both financial fitness and physical fitness are long-term goals. Sure, a lot of people like to drop some winter weight, slim down for a wedding, or get into “beach shape.” But those are all short-term goals. We don’t think you’d be reading this book if you were merely interested in growing your portfolio for the summer. We’re talking about lifestyle choices that you can follow forever because they are consistent with who you are.

Again we see that the psychological obstacles that impede getting into better shape physically are the same ones that hamper getting into better shape financially. People attribute the inability to get into better financial shape to ignorance and apathy. This is a common misconception. In fact, a study of 1,115 investors by the Guardian Life Insurance Company demonstrated conclusively that people know they should be saving more money and investing it for the future in vehicles that have shown long-term returns. The survey also found that saving money and investing for the future were consistently rated as top priorities.1 Yet the same study found that most respondents were woefully underfunding their retirements and risked hardship later in life.

We know what to do. We care. It doesn’t matter, because our investing problems lie deeper, in what we call human nature. You cannot change human nature. But it is possible to plan around it. When it comes to your finances, you have to.

Risky Business

One of the most basic tools used in the investment community is the risk tolerance questionnaire. If you’ve ever worked with a financial firm or professional, you know one of the first things he or she will do is have you fill out a short survey designed to measure your preferences for investment risk taking. The results are then used to generate an asset allocation model (i.e., a plan made up of different investment vehicles) that matches your inferred investing style.

Matching people’s investments to their personalities is a good idea. There is just one small problem with risk tolerance questionnaires. They don’t work. They explain only about 20 percent of the variance in the average person’s risk tolerance.2 That’s not to say there is no value in taking such a survey. It may lead to insights into one’s investing proclivities. It certainly makes a good conversation starter for expectations. But that’s about it.

The fact is human beings are lousy at predicting how they will react in future circumstances, especially those they have never encountered. The ability to comfortably handle financial risk is primarily what psychologists call state dependent (i.e., how you’re feeling at the time), rather than trait dependent (i.e., a consistent characteristic that doesn’t change).

In addition, there is no way to factor in all the ways in which one’s life might change in the future or what the future positive and negative circumstances might be. By the time we encounter the predicted scenarios, we might be very different people in entirely different circumstances.

Additionally, many risk tolerance questionnaires start from false or skewed assumptions. It is sometimes called the Dentist Analogy. Imagine you’ve gone to see your dentist and the following conversation ensues.

Dentist:I got your x-rays back and it looks like you’re going to need a root canal.You:Oh wow . . . that’s too bad.Dentist:Tell me about it. I have a three o’clock tee time, but there’s no way I’m going to make that now!You:So, is this a painful procedure?Dentist:No! Of course not! Usually. So tell me . . . what do you think is the most amount of pain you can stand during the procedure?You:What?Dentist:My model is to use as little Novocain as possible, so I need a sense of your pain threshold. What is the absolute most pain you can stand during the procedure?You:Look, I don’t think I want to—Dentist:Ah, don’t worry about it. How about you just tell me when it hurts, and I’ll add more Novocain along the way? Now sit back and relax. Open wide . . .

Of course, it deserves to be said at this point that no dentist would operate this way. But neither should an investment professional! And if you look at the assumptions behind using risk tolerance questionnaires you’ll see that the analogy is not far off. Many such measures essentially ask you to rate your various pain thresholds, and then seek to base a plan around the maximum pain you can supposedly tolerate. Most people are asked to rate their pain tolerance while sitting comfortably in their advisor’s office. Interestingly, because of a mental trap called the projection bias, it’s extremely difficult to accurately estimate how we’ll respond to pain in the future if we are not in pain in the present. To plan ahead for pain we’ve got to stay grounded despite changing circumstances.

Resisting Your “Idiot Friend”

An investing identity is important because it is so easy to get side-tracked along the road to wealth. Here’s a brief anecdote that you may find familiar: I was 16 years old and had just done something stupid but entirely typical for 16-year-olds. It led to the following exchange:

Mother:Why did you do that? Are you crazy?Me:But everybody was doing it!Mother:And if everybody were jumping off a bridge, would you do that too?

The preceding conversation has been happening between every generation of mothers and sons in the history of time and, presumably, bridges.

The last question is meant to be rhetorical, but is nonetheless worth answering, because the honest response in most cases is, “Yeah, probably.” What we see others doing around us has a profound impact on the decisions we make.

This exchange can happen between anyone, but it is most typical of teenagers and mothers. Why? Because the primary social developmental task of teenagers is to achieve a sense of “who they are.” This search for an identity leads teenagers to test boundaries, engage in risk-seeking behaviors, and, yes, be more susceptible to peer pressure.

As we begin to grow more secure in our identities, we are better at resisting thoughts and behaviors that seem at odds with our self-image. We say, “I know it seems like everybody is doing X . . . but I don’t like X. I’m not sure I ever did.” And this deeper knowledge and acceptance of who we are allows us to resist the crowd.

Short-term market moves are your “idiot friend.” Don’t know what I mean? Sure you do. You remember your friend back in high school who was always getting you to do dumb stuff. He (or she) used to say things like, “Let’s race that guy!” “Let’s dye our hair green!” and, “They won’t mind if we use their pool!”

These escapades usually started out great, but had a way of ending badly. How did your friend get you to engage in such foolish behaviors? Well, one reason is that the foolish behaviors are often fun—and we like fun. If we didn’t, we wouldn’t have the lottery, office pools, and the city of Las Vegas. But the second reason is that an underlying insecurity made you susceptible to pressure—usually in the form of such time-tested tactics as “You’re not scared, are you?” “It’ll only take a second,” and the aforementioned, “Everybody’s doing it.”

To a teen these are remarkably effective manipulators. The average adult, however, is more likely to respond, “Of course I’m scared!” “Nothing takes a second,” and “Everybody is NOT doing it and even if they were, I still don’t want to.” Such is the virtue of maturity.

The majority of investors are chronologically adults, but their investor identities are in an earlier developmental stage. They have some knowledge about the financial markets, but sometimes “just enough to be dangerous.” They have some insights into themselves, but lack the realizations born of experience. They are still in the process of learning their investing strengths, weaknesses, values, and pain thresholds. This leaves their decisions vulnerable to the influences of other people in their lives, talking heads on TV, or the greatest pressure group of all, “The Market” itself. Most investors are—and in no way is this meant to be pejorative—the developmental equivalent of adolescents.

There is a consistency of approach that forms with self-insight and allows us to resist such peer pressure. The investing industry is not the fashion industry, but it all too often markets its products that way. Many financial pundits encourage the investing-as-fashion outlook by touting the “hot” investing options of the season as if they are strutting down a runway.

Spring is here! The leaves are turning green and so is Cyndi’s portfolio! She looks positively verdant in this smart ensemble of solar, green-tech, and renewable energy stocks. Saving the planet never looked so good!

Come with Paulina this autumn to the exotic Far East. With the Red Star on the rise, you can’t help but “fall” for these hot infrastructure plays. And with an annual GDP growth of 8 percent and the world’s largest population, you won’t have to be Shanghai’ed into this spicy number!

The thermometer is dropping this winter, but Giselle is heating things up with these red-hot selections from the oil sector. An OPEC production freeze will send crude prices—and your temperature—headed to 100 in these oil and gas plays!

A new fashion is always alluring. But fashion is also capricious. It changes on a whim and without warning.

Most people playing along are behind the curve. They join the trend after it has become the “cool” thing to do, and when they get out, it is usually after the new trend has reversed itself. The result is a wardrobe stuffed with outfits they have no intention of wearing again. Take a look at a picture of you and your friends from 20 years ago. Would you wear the same style of clothes today? Maybe, if you were going to a theme party.

And this would be fine if we were really talking about clothes. But the investing equivalents of leg-warmers, bell-bottoms, and scrunchies not only don’t get sold off in a timely manner, they tend to collect in our closets (read “portfolios”), eroding our net worth in the process. (In later chapters we will discuss why the bad holdings tend to accumulate while the good ones tend to disappear.)

Some of us look back on those pictures of us with our friends 20 years ago and think, “Wow. I can’t believe I wore that. I look like a goofball.” It’s usually good for a laugh. But a trip down memory lane through the wasteland of our investing errors, and the thousands of dollars we squandered in futile and transient pursuits, seldom elicits a chuckle.

When it comes to finding good places to invest our money, the vast majority of us are better off sticking to the classics. The little black dress. The blue blazer. Are they exciting? Well, no. But the goal of investing shouldn’t be excitement. That’s an emotional goal in direct competition with our financial ones, and a huge red flag. Nor should the desire to “stay current” be a motivator. The true motivators should always be rooted in our consciously developed goals—how we want our lives to look and what we want our legacies to be.

Finding Your Investor Identity

Now, the world don’t move to the beat of just one drum. What might be right for you, may not be right for some.

—Theme song to Diff’rent Strokes

Have you noticed that it’s uncannily common to invest at the wrong time—buy at the tops and sell at the bottoms? (We call it “Whack-a-Mole” syndrome). For most investors, real estate in 2005 and Internet stocks in 1999 appeared to be good buys. For most people it was only in painful hindsight that the tremendous overvaluations were apparent.

If we were to tell you that you can expect to earn an average of 1.87 percent a year in the mutual funds you invest in, would you still invest in mutual funds? Of course not. You’d buy a Treasury bond or something safer (and higher yielding). Yet 1.87 percent is what Americans have annually earned on average in their mutual fund investments over the past 20 years through the end of 2008.3

Those numbers are bad enough. But they look even worse when translated into real-life returns. As mentioned in the Preface, Dalbar Inc. found that $100,000 invested in the S&P 500 index on January 1, 1989, would have grown to a total of $292,329 by 2009, after accounting for inflation. However, Dalbar Inc. found that the average equities investor who invested that same $100,000, again accounting for inflation, would now have $82,288 over the same 20-year period. That is a difference of over $200,000, not to mention a net loss in actual purchasing power.

How could the average investor underperform so poorly that they can’t even match the rate of inflation? Good question. Most of us don’t want to arrive at a party before it’s hopping or leave while we’re having a great time. The same goes for timing our investments. But the inability to do just that is a prescription for underperformance. Thinking counterintuitively about investments is crucial. But it requires tremendous fortitude, confidence, and self-awareness.

Unfortunately, many amateur investors scoff at the idea that psychology matters to their performance. Yet the best investors in history—including Warren Buffett, Peter Lynch, Steve Cohen, Baron Nathan von Rothschild, Bernard Baruch, David Dreman (and the list goes on)—have mentioned the importance of understanding the psychological factors that drive both markets and individuals.

Managing yourself—your moments of greed, panic, and insecurity—can only be achieved once you’ve obtained the requisite self-understanding. And self-understanding comes from looking within.

In this book we’re not endorsing any particular style of investing such as buy-and-hold or market timing. Nor are we endorsing any particular strategies (such as value or momentum) or assets (such as bonds, stocks, or commodities). Your optimal investing style and strategy depend on who you are.

If you’re going to be investing, you’ve got to back up and take a good look at yourself. Why do I want to invest? Who am I trying to be when I invest? What are my long-term (and short-term) objectives? How am I likely to deceive myself along the way? Although it’s important to answer these questions, they are incredibly challenging to answer honestly.

You may be wondering, “Why is knowing myself more important than knowing the markets?” It’s true that you’ve got to have an elementary understanding of markets, assets, analysis styles, and potential strategies in order to invest well. Yet many investors go further, spending weeks or months learning specific trading strategies, or watching price quotes day after day, and yet never seeming to get ahead (and usually falling further behind). And they wonder, “Why am I trading the best stocks/real estate/commodities, and I’m still not making as much money as I should?”

You might have heard the advice from finance academics who say you can’t beat the markets. They recommend you buy and hold low-fee stock index funds and forget the rest. When academics tell you to do this, they make it sound so easy. The more imperious ones seem to suggest you’d be silly not to do it. You may be surprised (if not amused) to know that most finance professors don’t follow their own advice. And that raises the question, “If it’s so easy to buy-and-hold low-cost stock index funds, why do the majority of mutual fund investors underperform?”

Let’s get real about something: You’re not designed to be a good investor.

No, we didn’t say “destined.” We said “designed”—as in anatomy. Investing is not like most other pursuits in life where the advantages can be readily seen. Great long-distance runners tend to be long and lean. Great pianists have long fingers. Great cyclists like to wear form-fitting spandex. And great investors, what are they like? Before looking into the secrets of great investing, let’s first look at the causes of bad investing, since in order to be the next Warren Buffett, you’ve got to avoid being the next Nick Leeson.