Friday, July 20, 2012

Thoughts on Investing from Above the Market

In today’s Bucks blog, Carl Richards addresses risk and makes three very good suggestions for managing your risks (with my comments in parentheses):

• Accept that there is no reward without risk (do the best you can and try to live with it);

• Practice a lifeboat drill (and remember — based upon actual data, not your subjective impressions, since they are likely to be wrong – what you did before, especially the mistakes); and

• Review economic and stock market history (“this time” is rarely different).
However, this advice does not provide why we keep making these mistakes. If we understand our mistakes and why we tend to make then, we have at least a fighting chance of overcoming them in the future.

In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). Most of us overrate our own capacities and exaggerate our abilities to shape the future. The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof. It’s at least partly why we underestimate risks and bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect. It’s why the results we achieve aren’t as good as we expect. Clients and financial professionals are both (all!) susceptible.

Another reason why this problem is so acute for advisors is the so-called “authorization imperative.” Our plans and proposals must be approved by our clients and we have a stake in getting that approval. This dynamic leads to our tendency to understate risk and overstate potential. Perhaps we see it as easier to get forgiveness than permission or perhaps it’s just a sales pitch. Or maybe we have convinced ourselves that we’ve got everything covered (confirmation bias!). Either way, despite its strategic benefits, we run the risk of serious misrepresentation.

Similarly, nearly every advisor works with individuals who say they are risk averse to varying degrees, but typically more risk averse than the advisor would like them to be. The tendency is then to try to convey to or convince the client that not being aggressive enough is a risk too – the risk of not meeting one’s goals. The planning fallacy is another reason not to push that approach too far.
Finally, and of course, the “bias blind spot” tends to cause all of us to think that only others suffer these types of problems — we’re being really smart and objective, it’s the other guys that….

Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973. His 40 years of investment experience includes institutional portfolio management at Scudder, Stevens and Clark and Bear Stearns. Steve's goal at Strategic Stock Investments is to help other investors build wealth and benefit from the investing lessons he learned the hard way.