By Emily Zulz, ThinkAdvisor
Investor misbehavior: It’s the scurvy of the financial services industry. So suggested Daniel Crosby, the psychologist and behavioral finance expert who recently co-authored Personal Benchmark. It took over 500 years for the official cure for scurvy, Vitamin C, to be established — despite the fact that cures were discovered time and time again throughout history. Citrus fruit was known to cure the sick when the Crusaders frequently suffered from the disease during the expedition of Vasco da Gama. Years later French explorer Jacques Carter used natives’ knowledge of boiling cedar needles containing Vitamin C to make a tea to save his men dying from scurvy — and yet the direct evidence of Vitamin C as the cure wasn’t established until the 1930s.
“Something similar is afoot in financial services today,” said Crosby, who is also president of IncBlot Behavioral Finance. “We now know that some of the greatest good that an advisor can do is hold the hands of their clients, to manage their behavior.” As evidence, Crosby pointed to how the market over the last 30 years has returned 11.1% a year while the average investor has held onto less than 4% “because of their bad behavior”.
Crosby said a recent study showed that 77% of financial advisors are talking about behavioral finance concepts — and yet investor misbehavior continues. In an attempt to cure what ails the financial services industry, Crosby provided ways investors should manage their behavior in the form of 10 commandments:
First Commandment: In all markets, up down and sideways, you control what matters most
Crosby said that most of the people he’s talked to that have failed to invest in their future haven’t done so because they feel helpless. “They feel rocked back-and-forth by volatility of capital markets,” he added. “They feel scared, they feel helpless, they feel afraid. They don’t understand that in all markets they control what matters most. That more important than all of this onslaught of information that they’re getting from financial news networks is managing their behavior.”
Second Commandment: Thou shall understand risk
Instead of the volatility-based notion of risk that everyone is familiar with, the idea of “risk” should be thought of in regards to behavioral finance and goals-based investing. “Risk is not a number,” he said. “Risk is not benchmark risk. Risk is not underperforming your golf buddy. Risk is the probability that you won’t have the money you need to do the things that matter most to you.” Even thinking of risk as volatility is a good thing, Crosby said.
Third Commandment: Start now, start again tomorrow and start again the next day
Mathematically, he added, this just makes sense. “If you’re trying to end up with $2 million in retirement, you’re greatly improving your chances of getting there by starting earlier,” Crosby said. “If you start at 22, you can give $6,000 a year. If you start 18 years later, you’re going to have to ramp that up pretty significantly.” But the other part of this is psychological, by forming and cementing habits in one’s mind. “If you can start saving, deferring, investing, being appropriately aggressive, whatever it is today, you are going to start to cement those behaviors for tomorrow,” Crosby said.
Fourth Commandment: Trouble is opportunity
Crosby, who has created a 0-to-100 index of market sentiment called the Irrationality Index, talked about when a few years ago that irrationality index reached the lowest point in its history, indicating revulsion with the markets. “It got down to five out of a potential 100,” he said. “You were there, you understand people’s reactions to this. But, if you had gone in at that 5, by this point you would have about doubled your money.” To help illustrate this point, Crosby quoted Sir John Templeton. “[Templeton] had this to say about this concept: ‘The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell,’” Crosby said. “And we’re all familiar with Warren Buffett’s admission about being greedy and fearful. Trouble really is opportunity.”
Fifth Commandment: Do less than you think you should
Elsewhere in life, to get something done or to get ahead, hard work is required. “[A]nd, yet, in financial markets we know that is not the case,” Crosby said. “You ought to do less than feels appropriate … When things get scary, we want to do the most when it’s exactly when we [need] to be doing the very least.”
Sixth Commandment: Forecasting is for weathermen
“The fact is we’re just not very good at forecasting much and especially not what the market’s going to do,” Crosby said. He added that listening to these types of “experts” is considered easier than educating oneself or talking to a financial advisor for an hour. “Get away from forecasting and move toward doing the right thing every day.”
Seventh Commandment: If you’re excited about an investment, it’s probably a bad idea
“Most investors are obsessed with doing whatever the exciting thing du jour is,” Crosby said. Take initial public offerings, for example. Crosby said his phone was blowing up all day after the recent Alibaba debut with clients asking if they should buy. “Investors should understand that on average IPOs underperform the benchmark by 21% three years on because they’re born on excitement,” he said. “They’re born in irrational exuberance, and people tend to do IPOs, of course as we all know, when the market is relatively elevated or there’s a lot of popular sentiment.”
Eighth Commandment: This time isn’t different and neither are you
In addition to having brevity of financial memory, Crosby added that people tend to have a belief in whatever is new in the world. “This has happened time and time again. When it’s some new product — whether it’s 3D printing, or a new drug, or airplanes, or the Internet — we believe when something new comes in the world that this time is different,” he said. “We believe that this will be the thing that revolutionizes everything and so often even when that’s true it doesn’t mean that it’s a good investment.” A belief in uniqueness and specialness, Crosby added, is usually correlated with bad things happening. “This time isn’t different, and you aren’t either.”
Ninth Commandment: You should be the benchmark
What Crosby means is goals-based investing. “One of the things that goals-based investing and personal benchmarking does is that it motivates positive saving behavior,” he said. Adding, “it’s not a matter of whether or not we’re going to benchmark. It’s a matter of what are we going to benchmark to. I would recommend to you that you benchmark to your very specific needs and goals instead of an external index, like the S&P or SPY.”
Tenth Commandment: Take this process and tailor it to your needs
As Crosby said, everyone is different. “Take this process and tailor it to your individual needs.”
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