Gil’s Musings

Predictably Irrational Investing

The field of economics has long assumed that people make decisions that optimize their own utility, and to derive the greatest benefit for themselves. However, psychological studies show that we humans do not do this, but rather we often make irrational choices, and we do so predictably. In this case, irrational investing choices.

The reason we do this is that we often value our emotional wellbeing more than money. Intangible benefits don’t fit nicely in the economics calculator. In his book, Predictably Irrational, behavioral economist Dan Ariely explores the biases that cause self-harmful human behaviors. I touched on many of these same issues in my new book, FOOLISH, which I’m happy to say made the Amazon Best Seller’s List last month.

In my 37 years of advising clients, I’ve seen this human irrationality play out in many ways. Last week, I witnessed a prime example of irrational investing at Taco Tuesday with old high school friends at Molina’s. The guilty party this time was a particularly misguided classmate of mine who had also come into my office two years ago seeking advice and sharing his dismay over the performance of his mother’s long-standing position in Gold. I then explained to him why stocks routinely do so much better than metals, but he and his mom were hung up on the periodic 40% declines that stocks endure, which he claimed he could predict. I think he meant that he could predict that another event would happen; he just didn’t know when. Unfortunately, the importance of that distinction was lost on him. Less than a year later, in March of 2020, his confirmation bias affirmed that he was right about the downside. He and his mom hung on to their Gold, and it has surely risen since two summers ago. But their Gold position has only improved by 10%, and stocks are up five times that amount. Maybe it was the margaritas, but he seemed comfortably oblivious to how right I had been despite the scary and brief market decline last Spring.  

Buy & Hold Strategy

As we dove into our tacos, he challenged the wisdom of the buy-and-hold strategy, despite the math running circles around his current holdings. He must experience the emotional trauma of downside volatility so pungently that he rationalizes steering clear of it altogether. He is also making decisions without a full understanding of the tentacles that ensnare him. For example, he did not know he was paying storage costs on his Gold, while alternatively, stock owners receive “rent” checks in the form of dividends, which are 76% tax-free. He also had zero understanding of the tax implications of rolling in and out of investments in attempts to “time the market” but he was sure that a magic-formula-type solution existed. 

As my indigestion set in, I reminded him that stocks rise in 81% of all 12-month periods; he returned to his justification that 40% losses loom large. The 81% I quoted includes those losses. He was also unaware of the fact that stocks have risen off those crazy declines of March ’20, and have since gained 40%… twice over. Again, I tried to explain that his bet constituted a “play” on the 19% chance of success, and his fear of loss made him lean away from the choice providing the 4x greater likelihood of success, and his method had negative tax implications as well. I felt like he had his fingers in his ears while saying, “NANANANANA.”

Even in the face of all the evidence I presented, he seemed convinced he was right in avoiding the chance of loss. His biases, built from his experiences, allowed him to justify to himself that he is doing the right thing. It is actually investors like this that make the pickings easier for the rest of us. As I said at the start, predictably irrational. 

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