ness, conservatism, and disposition effect. This article will introduce the first two.
Heuristics Rules-of-thumb allow for quick decision-making. However, they generalize on generalities—they may be a good place to start the reasoning process, but they are rarely the best answer in themselves for financial issues. An example of a rule-of-thumb is the 1/N rule. With N choices, you select 1/N of each of them. If the retirement fund has 3 investment choices, the first inclination is to put 1/3 into each one. In financial practice, a portfolio with 1/3 bonds, 1/3 U.S. stocks, and 1/3 International stocks would be appropriate for a small segment of all participants in such a retirement plan. We find corollaries to the 1/N rule. The first is “option overload.” We like choice; it lets us allocate 1/N where possible. However as N increases in value, we become overwhelmed. For example, watch a young child in a bakery who is told he can have only one choice—I have actually seen children break down and cry because they can’t make a selection. When the child makes a choice, he often regrets the decision once he receives his chosen pastry. So, too, retirement plan studies demonstrate that the percentage of participation goes down as the number of investment options go up. Another corollary is the “urgency imperative.” If we are told that we are about to lose a choice, we react irrationally. This is what hucksters count on when they tell you that “if you decide in the next 20 minutes, you get a bonus.” We instinctively want to act so we don’t lose the bonus. Or, current investors will consider putting more money into a mutual fund because it is closing. We don’t want to miss the opportunity to invest.
Overconfidence Jason Zweig, author of “Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich” (Simon & Schuster; 2007) makes the observation, “One of the most fundamental characteristics of human nature is to think we’re better than we really are.” He includes the following example in his book: in 1965, psychiatrists Caroline Preston and Stanley Harris published a study in which they asked 50 drivers in the Seattle area to rate their own skill, ability, and alertness the last time they drove. Just under two-thirds of the drivers said they were at least as competent as usual, describing their ability as “extra good” or 100%. However, these 50 drivers were all interviewed in the hospital—they were there because their last drive ended in an accident. The Seattle police reported that 68% of these drivers were directly responsible for their crashes, 58% had at least two past traffic violations, 56% totaled their vehicles, and 44% would ultimately face criminal charges. They suffered concussions, facial trauma, a crushed pelvis and other broken bones, and severe spinal damage. Three of their passengers had died. These drivers are not delusional. We naturally think we are better than we really are. Preston and Harris also interviewed people with a clean driving record—93% believed themselves to be above average drivers. Statistically, only 50% can be above average. Overconfidence demonstrates in a number of ways. First, we overestimate our chances at success, leading us to take risks we regret down the road. Second, we have “home bias.” We trust in what is familiar. Therefore, an investor tends to overinvest in their company’s stock, and invest too little outside their industry, region, or nation.
Business Management for Independent FInancial Advisors