October 16, 2013

Rational Investors

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Last week, I read an interesting article in an old Forbes magazine that described an experiment conducted by Dr. Dan Ariely, a bestselling author and Duke University professor of psychology and behavioral economics. In the experiment, participants were given balances on multiple credit cards with varying interest rates and varying amounts of income over a period of 25 rounds. Then they were asked to decide how they would allocate their income towards paying down their debts. The participants’ stated goal was to maximize the money left over at the end of 25 rounds. Now maybe I’m a finance nerd, but the cash maximization strategy seems fairly straightforward to me. One should probably pay down the credit cards in order of their interest rates from highest to lowest, with no regard whatsoever for the principal balance amount. To my surprise, Ariely discovered that almost none of the participants could stick to the optimal strategy. Participants were evidently too tempted to pay back the smaller loans and feel like they were making “progress.” Ariely concluded that the satisfaction participants got from having fewer loans open overwhelmed their ability to do the financially optimal thing. I can see how people might convince themselves to do this. Actually, I can see how I might even pay off some of the smaller debts first. This got me thinking, are investors really rational?

I think Merriam-Webster’s definition of the word rational almost answered my question for me right off the bat:

rational: having the reason to think about things clearly, based on facts or reasons and not on emotions or feelings

I have some friends, family members, and clients who can certainly think about their finances and investments pretty clearly, but I have others who don’t really get it, and some who don’t even want to get it. I also know that some of the times I have added the most value (financial and emotional) to people I advise financially are when I have helped talk them into staying the course with their savings strategy or investment philosophy and out of buying that breakout penny stock, piece of speculative real estate, or going to all cash, bonds, or gold. Wow! All those painful economic lectures in college on the efficient market hypothesisis just got crushed in a couple of minutes by a Forbes article and a brief look in the dictionary!

Look, I like to think of myself as a rational person, but in some areas of my life, I know I’m not. I'm always a proud believer that there is not a football team in America that could take my Georgia Bulldogs in a game in Athens on a fall day after a delicious tailgate. I’ve said at the end of every season since 1991 that the Atlanta Braves were going to win the World Series next season before the champagne was even popped by whatever team was the current champion (Hey, I was right in 1995!). I frequently waste time and gas on the weekends with no hesitation when I drive to the other side of town for a club sandwich that there is just something about, while knowing good and well that any one of the delis or sandwich shops I pass on the way could probably produce something almost identical. When it comes to the Dawgs, Braves, and club sandwiches, I don’t have the reason to think about things clearly, and my actions, statements, and decisions are often based on emotions and feelings. I’m okay with that, and I don’t think it’s that big of a deal because I’m not being irrational about anything that is actually crucial - like my finances.

I believe being rational when it comes to your finances and investments is very important. I believe you have to stick to your goals and the strategies needed to achieve those goals as much as you possibly can in order to have a realistic shot at achieving financial success. I also believe you have to stick with a prudent investment strategy with a long-term time horizon no matter how badly you may want to sell out at the bottom of a market downturn or get more aggressive at the top after a long market boom. Because some investors do get caught up in emotions and feelings, I think there are two clear takeaways: 1) it’s important you recognize the risk of getting caught up in emotions and feelings and try to stay a rational investor yourself, and 2) you may actually have an opportunity to benefit financially in the market because of others who are not rational.

You may still disagree and think investors are always financially rational, the market is perfectly efficient, and that you, personally, are always rational, but I bet I could counter those thoughts if I introduced you to a few investors I’ve met and took you to get one of those special club sandwiches on the other side of town. As Dr. Ariely put it: “For some reason people are willing to put their lives at risk because their phone vibrates for a second (while they’re driving), but when it comes to money…they think people are perfectly rational.”


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