Falling off the New Year’s resolution wagon is one thing; but investing money is rather more serious, writes Gary Connolly.
The beginning of each calendar year inspires many of us to think about the future and resolve to better ourselves in a quantifiable manner, such as losing weight, kicking some bad habit, or improving fitness levels.
However, initial optimism and hope very can often gives way to frustration.
Doing something you know you shouldn’t is easier if you can convince yourself that this will be the last time you indulge. So we convince ourselves that since we¹ll be strong in the future, we can still indulge today.
We delude ourselves into thinking that we will take the more difficult path next time.
Economists have actually measured this by looking at gym membership. A few years ago, two economists looked at the issue using gym membership data. They found that in a club in which non-members could pay a no-strings fee of €10 per visit, people preferred to pay the €70 per month for unlimited access.
And since members only attended 4.3 times a month on average, they ended up paying an average €17 per visit. The authors concluded this to be clear evidence of overconfidence about future self-control.
If I was the owner of a gym, how am I likely to respond to these findings? The best pricing structure is one that involves below marginal cost pricing of attendance, automatic renewal and a transaction cost on cancellation.
And this is exactly how most gyms are priced. Contracts, whether it¹s for gym membership or any other product or service we buy, will be designed so as to be consistent with consumer behaviour. No major surprise there, but the implications of this when we apply it to investments and investment products, is potentially destructive to our wealth.
Financial products are often abstract and intangible with many features and complex charging structures. Faced with complexity, people simplify decisions in ways that lead to errors. In addition, many products involve trade-offs between the present and the future. If we are overconfident about future self-control we may borrow excessively today.
ILLUSION OF CONTROL
The authority on all things behavioural is Daniel Kahneman, who believed the combination of overconfidence and optimism is a potent brew, which causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. It also leaves them vulnerable to statistical surprises.
For investors, overconfidence and the illusion of control can result in over-trading and a lack of diversification.
Financial products are often abstract and intangible with many features and complex charging structures. Faced with complexity, people simplify decisions in ways that lead to errors
The average stock market investment is now held for about 12 months, compared with five years in the 1970s.
The vast majority of the return from buying shares over five years comes from business fundamentals, so if you are buying stocks then selling them a few months later, the aim is clearly not to participate in the build-up of value.
The average holding period for a stock on the NYSE is just 12 months. The idea that an investor can consistently turnover a portfolio at a high rate and make money is a fiction convenient only to the croupier at the investment table.
The role of overconfidence in prompting under diversification is based on the notion that, if you know you are right, what’s the point in hedging your bets? If you are open to the range of possibilities that could actually happen, decision-making will inevitably improve.
THE CRITICAL VIEW
The role of an investment adviser or someone unconnected emotionally from the investment and a written plan is critical in my view. The process of writing an investment plan forces a client to work with the adviser.
This activates the rational part of the brain and links a portfolio with long-term goals. This helps us to extend our investment horizon, making us potentially more relaxed in the face of inevitable swings in the value of risky assets.
Investing is never easy, but it can be simplified. Start with a proper plan, get some external input and take it from there.