Thinking fast and slow.

I thought I’d share a short book report on a couple of chapters in a book I read while traveling to and from El Salvador. By repetition of the academic approach you and I utilize there is reinforcement of the message I´ve given before as to why we are using a structured approach as we are and what are the rationales, both investment and behavioral, that underlies this academic approach. Here are a few points from the book that apply to you …

Thinking, Fast and Slow by Daniel Kahneman

OnWallStreet has a great “Five Questions with Daniel Kahneman” article about how to think fast or slow when it comes to the markets.

Chapter 20 – Illusion of Validity, had a section about stock picking skill. You make an impression based on the factors present at the time (Kahneman calls this WYSIATI – What you see is all there is). And even through you are presented with proof that your impression is not valid, you ignore the proof and continue to believe your impression, mainly because the factors are still present telling you otherwise. Can people actually pick stocks to consistently, year after year, beat the market … and secondly, can anyone pick that person in advance?

My 2 cents: Wall Street and brokerages continue with their marketing messages, through many forms of media communications that bombard you and me on a daily basis, in order to continue to support impressions of the validity of stock picking skill. This is despite academic research that shows consistency in stock picking is in the realm of luck statistically in the short term, and does not persist in the long term. This is also despite that fact that one cannot identify ahead of time who it will be that will be lucky (or unlucky for that matter). You can only get results ahead of time … after the fact purchases do not get past returns, they get future (the unknown today) returns. (This phenomenon is called Hindsight bias). Thus we use passive indexing to give us what the markets provide in each key asset class dimension utilized.

 

Chapter 27 – The Endowment Effect, discusses the behavioral effect of how hard it is to give up something once you have it. There is a difference between having something “for use” and having something that you own with intent to “exchange it.” It is hard to give up something you are using, but you are not giving up anything if you intend to exchange it. Money is in the exchange category, and stocks tend to be in the use category … it is not hard to give up money to buy stocks, but then it is hard to give up the stocks for money again because you intend to use the stocks later … and which stock to sell becomes a difficult choice as well.

My 2 cents: The impact of this effect is to make it hard to sell any stock once you have it. The portfolio approach we use puts stocks into the proper mental category for purpose of later exchange (to sustain your Standard of Individual Living in retirement for example). Stocks are still present, but the mental blocks are gone because you are not emotionally attached to them specifically by name. Thus, when the time comes to exchange again, the mental blocks are not there that would otherwise cause confusion (i.e., which one to sell now?).

 

Chapter 31 – Risk Policies discusses how we feel losses twice as strongly as gains. Here’s the effect …. Have you noticed that it feels like the past year has been bad or not so good?

If you feel this way, it may be because of this effect … it takes many compounded gains to have us make up the effect of the feeling that results from losses … even though the gain and loss may net to zero … we feel as though we’re behind because the loss is felt twice as powerfully as the gains. Thus constant bombardment from wall street, brokers, and the media about the volatility of the markets makes us feel as if nothing is going anywhere.

My 2 cents: Indeed, the Dow started 2011 at 11671 on Jan 3 2011, and on Dec 30th it closed at 12218 … (a +547 point change for the year) it is up just a bit … but it doesn’t feel that way.*

*I use the DOW as a reference since that is the most familiar index to most people. The S&P500 started the year at 1272 and ended the year at 1258 (a -14 point change). Of course, your actual portfolio results will depend on the weighted average of the asset classes you have.

If you check your account balances often, you are also compounding this feeling effect if markets are going down. This explains why some people don’t open their statements or check balances when markets go down. Indeed, they may recover their feelings faster than those who do check balances often because they have not accumulated the negative feelings that they need to be overcome in order to feel better again.

This effect is also felt when it comes to retirement planning. The sense of loss is so overwhelming that it feels like there’s no point in planning. However, this is just what you should not do … you should plan since that’s a positive action which may help overcome the negative feelings that have accumulated. If your portfolio values are down, it doesn’t mean you can’t retire … it just means you may need to cut back a bit when you retire. Look at all the retirees already retired. Those who planned properly don’t need to go back to work … they just cut back a bit.

Thus markets and the economy affect everyone, and nobody can escape those effects. But there are actions that can be taken (see Set the Sails next).

There are many other behavioral aspects to how to approach money in Kahneman’s book as well. These behavioral aspects are also a result of Dr Meir Statman’s research and influence that has been applied and utilized in your Structured Investing portfolios.

 

 

We can’t control the winds, so let’s learn how to set the sails.

We can’t control the economy or the markets. However, there are rational methods to adjust what we do as a result.  Those methods are what I discuss in many of my blogs.

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