Episode: 1-25-2022 | The Psychology of Investing

Hosted by Kevin J. Zywna, CFP® and Allison K. Dubreuil, CFP® Dollars & Common Sense · The Psychology of Investing 5 Psychological Factors Behind Bad Investment Decisions Allison Dubreuil, Wealthway Financial: Good evening. I was thinking today we usually focus a lot on financial planning because we feel very strongly that you should get financial […]

Hosted by Kevin J. Zywna, CFP® and Allison K. Dubreuil, CFP®


5 Psychological Factors Behind Bad Investment Decisions

Allison Dubreuil, Wealthway Financial: Good evening. I was thinking today we usually focus a lot on financial planning because we feel very strongly that you should get financial planning advice first, and then look for investment advice. But tonight we’re going to talk about investment decisions and the psychology behind bad investment decisions so that, hopefully, you can learn from others’ mistakes. And and try to identify your own biases or blind spots so that you avoid some of these common pitfalls and traps that we see people fall victim to.

Kevin Zywna, Wealthway Financial: Investment management is a core competency of ours, and like you were saying, although it’s important, it’s fundamentally important to achieving long term financial security. Good investment management is probably only about 25% of our value to our clients. We think about 75% of our value, we feel, comes through financial planning analysis, financial planning recommendations.

It’s there, where we can add tens, hundreds, sometimes millions of additional dollars of net worth over a client’s lifetime. But investment management is the engine that drives a lot of that. So it’s important to discuss what is good investment management because there are a thousand different ways to do investment management and everyone thinks they have the one way.

Of course, we will go through some of the strategies and some of the philosophies that we believe in, that are time tested, that are enduring, that have proven over long periods of time to be successful. And then allow you to make your own choice there. But hopefully, you find these tidbits helpful.

Allison Dubreuil, Wealthway Financial: The first thing we need to talk about, though, is human nature. So when it comes to investing, we are all absolutely our own worst enemy. We all get excited by profits. We get scared when there are losses. We let our emotions and our minds play tricks on us, and that inevitably often leads to making terrible investing decisions.

You know, everybody knows the basic rule of thumb. Buy low, sell high. But our fight or flight impulses that are ingrained in us are telling us that when things are high, we should be buying and when things are low, we panic and we sell. So this is pretty evident, actually, if you look at the statistics of an individual, investor’s return versus the market return. So if you had just invested in an index and bought and held it over the past 20 years, your average annual rate of return would be 7-7.5%. But an individual investor’s average return has been much less, probably 5-6% over that time period.

Kevin Zywna, Wealthway Financial: Yeah, that’s a pretty famous study in the investment management world that gets updated every year is what the average investor earns compared to other asset classes or other market indices. And yeah, so the S&P 500 index, one of the most widely followed indexes in the country over the last 20 years, has averaged about 7.5% annual growth rate each year.

But the average investor, and this is higher number than it’s been in the past, who either market returns have been favorable, or people are getting a little bit smarter. But just a shade under 6% over the last 20 years. Now that’s not bad, but I will say when you do the math, and we know this internally, how investment management works – 1% difference over an extended period of time is a huge amount when it comes to the additional dollars that you have. So when 1.5%, compared to the index, compared to the average investor, then that’s a big number. So what is causing the average investor, these are typically the do-it-yourself’ers to underperform general basic indices?

Psychology Behind Bad Investment Decisions #1: FOMO – Fear Of Missing Out

Allison Dubreuil, Wealthway Financial: Yeah, we’re all susceptible to these things. The first one is FOMO. Do you know what FOMO is?

Kevin Zywna, Wealthway Financial: Well, yes. I mean, yes.

Allison Dubreuil, Wealthway Financial: This is a term that gets used in my family a lot because we all have it.

Kevin Zywna, Wealthway Financial: As a non-millennial. I do know that it means fear of missing out.

Allison Dubreuil, Wealthway Financial: Yes. And I have this bad. I do not like to miss out. I do not like anyone to have fun without me. So I understand. But FOMO, fear of missing out, when it comes to investing – is a real thing. So we have herd mentality. And when we start to hear of everybody jumping in the market or jumping into a certain investment or stock, we jump on the bandwagon. And we can, at times, follow it right off a cliff because it was the popular thing to do. And we didn’t want to be the dummy who didn’t buy GameStop or bitcoin.

Kevin Zywna, Wealthway Financial: And that’s being borne out in some of the new stock trading apps that have come on the marketplace recently. Robinhood being one of the more well known that have sort of gamified the idea of investing and giving you tokens or trinkets or confetti when you do something. The party. Buy or sell and say were participating. And it sounds like fun. Well, you know, here’s the inside scoop. Good investment management is boring. Good investment management is systematic, process-driven and formulaic. If you’re just throwing money at hot names because your friends are all talking about it and you fear not getting on the bandwagon, that’s not investing, that’s speculating or gambling. It’ll catch up with you. You’re doing it wrong.

Allison Dubreuil, Wealthway Financial: Yes. So the remedy, I think, is to be a first of all, be aware of this. Know that if something is trending on TikTok or wherever you get your news or information, it’s probably a little too late. Professional investors have already been way out in front of this. And by the time you’re hearing about it, it’s probably overvalued and everyone has jumped on the bandwagon, so it’s better to come up with a long term approach and invest for the long term. And when you’re choosing your investments, choose them for the intrinsic value or the underlying value – the value and what that company provides, the services or the goods or in terms of, you know, what role it will play in your portfolio, not in terms of what the keeping up the Joneses are doing.

Kevin Zywna, Wealthway Financial: I will estimate that, oh, probably at least 80-90% of people who invest themselves don’t even know what you are just talking about there when it comes to the valuation of a company or how to properly value a company, or even if they can value the company, if that. To properly analyze whether that value is high or low, because that’s the course work that they typically teach a higher level college courses. And unless you are a corporate finance major, then you probably never got exposed to it. While it’s certainly learnable through other sources. Most people don’t invest the time, effort and energy into learning those things. So what should you do? I estimate overwhelmingly the majority of people don’t do so right off the bat. You’re going to face an uphill battle.

Allison Dubreuil, Wealthway Financial: Right. And that’s why we like the use of mutual funds and exchange traded funds rather than individual stock holdings. Because with that, and a mutual fund or an exchange traded fund, you have a manager that’s making those buy and sell decisions within the fund for you and choosing which companies or stocks have value and are worth investing in. Unless that’s your full-time job, then you’re probably just taking stabs in the dark or guesses.

Kevin Zywna, Wealthway Financial: Yeah. Preferred investment vehicles, some active managed mutual funds and a fair number of unmanaged index like exchange traded funds, both mutual funds and ETFs. Exchange traded funds have some similarities. Both are a bucket to hold anywhere between typically 25 to upwards of 500 individual stocks. So yes, investing in individual stocks is a different animal than investing through mutual funds in stocks through mutual funds or exchange traded funds. And for most individual investors, they don’t have to subject themselves to the individual stock risk in one company. A company can go out of business, which means its stock will go to zero and stay there and you’ve permanently lost that money. That risk is basically taken off the table when you invest through mutual funds or exchange traded funds because they are instantly diversified investment vehicles. Tonight we’re talking about some of the investment influences that cause people to make suboptimal decisions and underperform long term investment averages.

Psychology Behind Bad Investment Decisions #2: Overconfidence

Allison Dubreuil, Wealthway Financial: We’ve been talking about the psychology behind your worst investment decisions. Some of the things that play into our decision-making when it comes to investment management and how that doesn’t always serve your investment plan. We talked about, first and foremost, FOMO – fear of missing out. So jumping on the bandwagon when everyone else is talking about a popular investment.

The second psychological, or we’ll call it a behavioral factor, that we need to be aware of is called overconfidence. So when we overestimate our abilities, we think we know better than everybody else what the market is going to do next. And what we’ll see about that is no one knows what the market is going to do next for certain. Certainly, some people can get lucky from time to time, but there is no one that can consistently accurately predict exactly what the market is going to do

Kevin Zywna, Wealthway Financial: In the short run is certainly day to day. The short run is a week. The short run is a month. In investing we consider short run anything from one to three years. So yes, the market cannot be time. That is proven. It is random in the short term on day to day movements. But yet that doesn’t stop a whole bunch of people from thinking that they can predict where it’s going to do in the short term.

One of hobby of mine is I’m on a couple of chat boards that usually relate to sports, but they usually have some aspect of the board that talks about finances. And it’s amazing how many people on the finance chat boards have strong opinions about where the Dow or where the S&P is going to go. You know, in the next week or in the next month. Yes, I’m like, that is fascinating to me that people with such certainty and conviction would talk about these things as if they had some sort of inside knowledge of how it’s going to perform. We’re professionals. We live and breathe this stuff every day. We don’t know. No one knows. Anyone who tells you they know is lying in the short run.

OK, long run, we can use statistics and statistical analysis to give us a high probability, not a guarantee, but a high probability of conviction of where the investment market might be, say, seven to 10 years into the future. That’s when we get some predictability, a level of predictability around what our investment decisions might turn out to be.

Psychology Behind Bad Investment Decisions #3: Confirmation Bias

Allison Dubreuil, Wealthway Financial: And that’s why you should approach your investment plan with a long time frame, with a long looking lens. So that you don’t react continuously to the short term ups and downs of the market. And the next bias that we are all susceptible to is called confirmation bias. So that’s when we are living in an echo chamber and this can apply to anything, not just investing, but we, as humans, tend to seek out information that confirms our beliefs.

Of course, we want to be right. We want to make sense of the world and we want to have confidence in our investment plan. But you need to make sure that you’re seeking out complete information, not just information that confirms your opinion.

Kevin Zywna, Wealthway Financial: Yeah, one of the basic tenets of good financial analysis and investment management is to try to have a contrarian viewpoint from the consensus of the market. Something that you know, essentially when everyone is zigging, you would prefer to zag. In the short term that can be difficult to do and painful, sometimes in the short term. Long run that’s usually a good strategy for outperformance if you can stick to a good investment. Discipline, so really following the herd or confirming what you already believe to be true is typically suboptimal, let’s call it from an investment management standpoint, you should always be challenging your investment thesis.

Psychology Behind Bad Investment Decisions #4: Loss Aversion

Allison Dubreuil, Wealthway Financial: Yes. Good word. OK, then the next bias or human instinct that really, really, really does cause problems when it comes to investing is loss aversion. So our brains are wired to feel pain and loss more intensely than we get pleasure from gains or wins or positive events. So that means losing $100 feels twice as bad as winning $100, and there are lots of studies that show this proof. So what happens with investors is when the markets start going down, they want to sell because they’re worried about losing more and will do anything to stop the bleeding. And then typically they end up selling at the worst possible moment and making it a decision that’s going to impact their plan for the long term.

Kevin Zywna, Wealthway Financial: The pain of the loss aversion causes you to do improper, irrational things. Be careful.

Kevin Zywna, Wealthway Financial: Tonight we’re talking about some common investment mistakes that the average do-it-yourself investor tends to make to lower their overall long run rate of return. If you want to jump in on the conversation about that or anything having to do with the personal financial situation, give us a call. Right now, we’re going to run out to Virginia Beach and speak with Mark. Good evening, Mark. You’re on Dollars & Common Sense. Thanks for holding.

Which Inflation Rate To Use For Retirement Planning

Mark, Caller: Oh, no problem, thanks for taking my call. My question is that most financial advisors seem to be using three percent as an inflation rate for retirement planning. And with the inflation rate being much higher than that right now, I was wondering what you thought about what should be used.

Kevin Zywna, Wealthway Financial: Hmm. All right. Well, good. Good question there, Mark. So the long term inflation rate is three percent, or three point one percent over the last approximately 100 years. Now, obviously, with averages, just like your average return, you can deviate wildly from that average from time to time. We’ve actually been in a real good run for over a decade. I would say inflation year over year has been below trend, below three percent, for a long time. So we’ve only just recently in the last, say, quarter or maybe even year if we stretch it out, experienced some above trend inflation. So from a planning standpoint, we still believe the three percent is a good long term planning number. And that we should not deviate dramatically from that just because of what’s happening. In recent times, that makes sense.

Mark, Caller: Yes. Would that also apply if you were going to retire in the next year or two?

Kevin Zywna, Wealthway Financial: Yeah, I think it does. I mean, we we would be using three percent as the planning inflation number for the next year as we do our projections. That’s the number that we use for the next 10-, 20- and 30-year projections that we do for our clients. It’s still a good planning number. I know there’s concern that higher than average inflation is on the horizon, and that very may well be. But that also, you know, can change. That could be for another year or two. But that’s not long term. That’s still considered short term from our perspective.

Mark, Caller: Okay. I appreciate it.

Kevin Zywna, Wealthway Financial: Yeah. All right, Mark, thanks for the call. We appreciate it.

Allison Dubreuil, Wealthway Financial: Yeah, we do hear a lot of concerns about inflation recently. And that’s why we feel so strongly in good investment policy. Because investing in long term equities is the best hedge, are the best way to outpace inflation over the long term. So we help our clients maintain a growth oriented portfolio where the, you know, stock market has averaged 10 percent annual average return over the past 20 years, 30 years versus inflation at three. Even if it creeps up to four five, you’re still significantly outpacing inflation and preserving your purchasing power. So that’s why investing is so important, right?

Kevin Zywna, Wealthway Financial: And why we don’t recommend that people put too much money in bank type of assets like savings accounts, checking accounts, money markets, CDs. Those instruments provide the illusion of safety because they don’t fluctuate in value very much. But they also don’t keep pace with inflation. And so every year, you’re actually losing a little purchasing power to the corrosive effects of inflation. Like I was talking about at the top of the show, a one percent differential, you know, is a huge number in dollars when it comes to a long time horizon, a long hold period like 20 or 30 years. So if you’re only getting one percent in your bank account, but inflation is averaging three, you’re underperforming by two percent every year, that’s going to catch up with you.

Psychology Behind Bad Investment Decisions #4: Loss Aversion, Continued

Allison Dubreuil, Wealthway Financial: OK. We’ve been talking about investment mistakes or the psychology behind some of your investment mistakes. We’re all human, and as humans, we are hard wired to make certain assumptions or certain bad decisions when it comes to investing. The last one we just talked about before the break was loss aversion, which I think is one of the ones that so many people fall victim to. That’s when you start seeing a decline in your investments and you sell out to stop the bleeding.

Think of it this way. If you are thinking about whether you should buy or sell an investment, swap out the word investment and let’s buy something else like cereal. What if you were going to make a decision on whether you should buy or sell cereal? If you went to the grocery store and you saw cereal on sale, you’d be like, ‘Oh, I should buy and I should buy double. I should stock up, go to Costco and buy in bulk.’ That’s how you want to be thinking about your investments. When your investments go on sale, that’s the time to buy. It’s not the time to sell where you permanently lock in your losses.

Kevin Zywna, Wealthway Financial: And a lot of people have a hard time grasping that concept. Or at least maybe intellectually, they understand it. Their head understands it, but the heart overrules the head. And when we are going through a significant decline or pullback in the market, it feels like the world is on fire, that everything around you is crumbling and we are headed for Armageddon. It’s hard to look past that and commit to buying when things are on sale, because when stocks are on sale, there’s usually a short term reason for or concern about it. That makes people nervous.

You’ve got to look past that and focus on long term. I can assure you, whenever we have a market pullback or decline and we buy for our clients with excess cash that might have built up in the account. When we look back a year to three years, we always that’s where you get your highest long run returns. When you had the courage or the system in place to force yourself to buy low through a downturn. So you having a system and a process helps you overcome the emotion that wants to prevent you from doing the right thing.

Psychology Behind Bad Investment Decisions #5: Doing Nothing

Allison Dubreuil, Wealthway Financial: And to kind of go along with that…One of the other, I think, key things that we as human beings struggle with is the idea of just doing nothing. So sometimes the best course of action is nothing, just to stick to the plan and wait it out. I think we feel like we’ve got to take some action. We’ve got to try to correct course. But that, then, means we’re trading too often. And we’re probably trading at the exact wrong time because we’re doing it for emotional reasons, not for methodical planning reasons.

Kevin Zywna, Wealthway Financial: Yeah, if you don’t have an investment policy, if you don’t have an investment plan – and this doesn’t have to be written down in dogma, you just have to have an ethos. You have to have conviction that you know that your investment plan is solid. If you don’t have that, then that will cause you to want to do something when markets decline. When in fact, if you have the strategy and the plan in place, that’s usually the time to do nothing. Or, if anything, take the buying opportunity to buy more.

4 Steps To Making Wise Financial Planning Decisions

Kevin Zywna, Wealthway Financial: OK, we were talking about some of the mistakes, behavioral mistakes, that the individual investors typically make to lower their long run rate of return and cause them to underperform dramatically from long term investment rates that they could otherwise enjoy. So we’ve been through a fair list. One of the things that we should talk about is, OK, how do you do it? Then how do you do it right? If most people do it wrong or at least do its job optimally, how should you do it?

Well, we’ll give you a big picture framework of how we do it to ensure that our clients enjoy the highest possible risk adjusted returns for what we’re trying to accomplish. So here are the main drivers of performance from our standpoint.

#1: Wise Investor Behavior

Number one, as you may have guessed throughout this conversation, is investor behavior. What you do or don’t do from an investing standpoint, what you how much you invest or don’t invest when you invest or don’t. Because you’re either waiting for the downturn or you think stocks are too high or you’re scared about where the market level is now, you’re buying and selling decisions are the largest determinant of your long run rate of return.

Commit To Investing When You Have Money To Invest

So in order to give yourself the greatest chance of success. You’ve got to commit to investing when you have money to invest. When’s the best time to invest? When you have the money. That’s when you invest. When’s the best time to sell? When you need the money from your investments. It has nothing, nothing to do with where the Dow Industrial Index is or the S&P 500. It all has to do with your commitment to being an investor, or not. That is the largest determinant of your long run rate of return. Right. There you.

Allison Dubreuil, Wealthway Financial: It’s kind of like New Year’s resolutions and people that want to lose weight and get fit. There’s no magic bullet or hot stock tip that’s just going to change your life forever. It’s being disciplined and following a plan over long term that will get you results much like eating healthy and exercising.

Kevin Zywna, Wealthway Financial: So you have to commit to, I’m going to be an investor. I’m going to build up my emergency fund in my bank. I’m going to make sure I have enough money there to take care of the next three to six months if any sort of emergency befalls me. But over and above that, I’m largely going to take my excess cash flow and contribute to my company retirement plan and make sure that I get it, invest in equities. Or I’m going to contribute to an IRA, Roth IRA. Or I’m going to be an investor. That is the number one step. And you’re going to be an investor for the rest of your life. OK, that’s step number one.

#2: Appropriate Asset Allocation

Kevin Zywna, Wealthway Financial: Number two, asset allocation. Now I get a little bit more technical. Asset allocation, the makeup of your investment pie. What are the main categories allocations of investments that you hold in your portfolio, the whole grouping of your investments?

Largely speaking, very broadly speaking, those asset classes are stocks, bonds, cash. That’s very basic and very simple. But how much you hold in each of those (categories, stocks, bonds, cash) is the second most important thing to determine your long run rate of return.

The more you have in stocks, the higher your long run rate of return. The more you keep in cash, the lower your long run rate of return. So that’s the next big effect. Now there’s a lot of subcategories in asset allocation and stocks and in bonds. We’re not going to get into all those, but just know that your overall mix of how you invest is the next important determinant.

#3: Evaluate The Cost Of The Investment Vehicles

Kevin Zywna, Wealthway Financial: The third most important thing is the cost of the investment vehicles that you use. There was a time when trading activity came with a trading commission and was a relatively high cost to the proper functioning of investment management. Buying and selling to rebalance a portfolio, say, that has largely gone away.

Most commissions are now non-existent to most all the online brokerage firms and banks. Maybe people who call in and verbally give trade orders to individuals, which I’m sure still happens. Pay somewhat of a commission, but it’s not as much of a friction as it used to be.

Where costs do show up are in investment vehicles like mutual funds or exchange traded funds or annuities. And there is where those expense ratios can drag on your performance, so it is prudent to try to get the lowest cost for the type of vehicle that you’re trying to use that does, I should say, the best value.

Because it’s OK to pay more for anything if you’re going to get more. And while Vanguard we love Vanguard, we use some Vanguard products in our clients’ accounts. They are not number one. You might be surprised  to know, they are not always the cheapest. And then number two, they tend to have a certain philosophy that is maybe good for do it yourselfers no frills bare bones, but doesn’t work for everybody. Just know that cost is next important.

#4: Timing & Product (When You Buy & What You Buy)

Kevin Zywna, Wealthway Financial: And then finally, the fourth indicator of your long run investment drivers is a tossup. I got 4a and 4b. Short run market timing does have a small impact. So when you choose to invest where the market levels are, where your investment mark your mutual fund, your exchange traded fund, where you buy does matter. it’s better to buy it low than is to buy high. And therefore be the security selection the actual stock bond mutual fund ETF that you purchase. That is among the least important decisions when it comes to your long run investment performance.

Now what I have just told you is basically heresy in some circles. Some people, a lot of people, I would still say, make their living, selling, investment performance and selling you on the idea that their market timing and their security selection is most important to your long run investment performance. It is not. Factually, it is not. They might be able to outperform briefly over time, but those other bigger decisions have much more influence on your performance than security, selection and market timing. Yet we still live in a world where overwhelmingly most people think that is most important when, in fact, it is not.

Financial Advice Vs. Investment Advice

Allison Dubreuil, Wealthway Financial: And that’s why we still see so many people going to financial advisors first and foremost for investment advice instead of financial advice. And where it should be the reverse, you should be seeking out competent, trustworthy financial advice to help you make the right behavioral decisions. First and foremost, because that is going to have the most impact on your long-term financial success and then get into the investment management details. But first and foremost is investor behavior and big financial strategies. And we’re talking anywhere money touches your life. It’s not just in investments, it’s, you know, real estate, mortgage strategies, how much you’re saving. I just remember when I first was learning this business and it dawned on me, ‘Oh, I can’t solve everybody’s problem without adjusting their spending and savings.’ That’s the number one indicator of success. So look for financial advice first and investment advice second, right?

Kevin Zywna, Wealthway Financial: And really, that’s how you design the optimal investment plan. First to determine your life goals and how much growth you need out of your investment. And that then drive the asset allocation. And there’s no need to compare your investment man your investment strategy to an index like the S&P 500. Who cares? That’s not relevant. What matters is, are you your assets growing fast enough to achieve your life goals, like putting your kids through college, being able to retire on time, not running out of money.

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