Just the other day, I was having lunch with a client and friend (we’ll call him ‘Bob’) who relayed a story about a friend of his that was rather interesting. Both Bob and his friend are small business owners and face a “problem” that my experience tells me is fairly common for all kinds of folks. Specifically, Bob shared with me that his friend had excess money in the bank, which he had chosen to invest. Bob explained that he was in a similar situation, and described his friend and himself as hating the fact that the money might just be left to sit in a bank account.
I get it. I mean, what could that money be doing? More precisely, what could that money be earning?
Essentially, what we are talking about here is opportunity cost. In other words, by leaving money in the bank, you are foregoing potential returns (and losses) to be earned elsewhere. While I do understand not wanting to squander potential, the potential of any investment is a double-sided coin. In other words, the potential reward is inextricably linked to potential risk in the investment world.
The greater the potential reward, the greater the potential risk. The greater the potential risk, the greater the potential for loss.
Now, if it is truly an excess amount of money that Bob and his friend are dealing with, then that means that the loss of that money would not compromise the lives they want to enjoy—i.e., it’s not needed. Having said that, though, it’s not like you would walk outside and light money that you don’t need on fire. Doing so would represent a sure loss of that money, and regardless of whether the money is truly needed or not, the person who would light money on fire would seem to be a very rare species.
This illuminates something about emotional investors, however, that I hear very few people, if any, acknowledge: the decision to invest is typically based on potential reward and the decision to divest is typically based on the actual experience, not the mere potential, of risk—i.e., a loss. In other words, if we had excess money just sitting in the bank, like Bob and his friend, and we decided to invest it, would we not do so because of what it could potentially earn elsewhere? If we were to see the value of that investment begin to drop precipitously (the performance equivalent of the money bursting into flames), would we not have an emotional reaction to that? And might that reaction not be sufficient to lead to the investment being dumped?
If the decision to invest is based on potential reward and the decision to divest is based on actual losses, then investing money is based on the abstract of predicting the future and divesting is based on the concrete of what has actually transpired. How can the acquisition of, and the divestment from, the same investment be approached from two completely different perspectives? There seems to be something very off about this.
You Cannot Merely Run Away from Something
A favorite principle of mine: when you run away from something, you are simultaneously running toward something else. It’s just like one of those cheesy horror movies. As the suspense picks up and we begin to reach the climax, it’s all but inevitable that we will be treated to one of those scenes where an unwitting damsel seems to be on the precipice of her death, with her killer bearing down on her. The damsel, however, typically demonstrates a fleeting moment of perceived brilliance by finding a way to briefly escape, only to extend the scene for another mere 15 seconds. The close of the scene is all too familiar, of course, as her inevitable demise plays out immediately afterward.
The abrupt escape attempt proves only to offer false hope to the damsel, and us, the viewers sitting on the edge of our seats, as it proves to be no real escape at all. The explanation for this outcome seems to be explained by one thing: the damsel did not develop a well-rounded understanding of that toward which she was running. In other words, had she deliberately evaluated her potential moves, she might have discovered the fault(s) in the choice she made and excluded it from consideration. The fact that such a deliberation doesn’t take place is probably best explained by a fixation on that from which she was running. In other words, the fear associated with the circumstances from which she sought to escape was so consuming that a proper evaluation of the options toward which she could run was never in the cards.
A fear-driven decision to divest from an investment is really no different. There is no doubt that the experience of fear, as well as some other negative emotions, is very real for the investor who watches an account value decline, particularly in a precipitous fashion. But merely escaping the risk of the investment you are leaving does not address the risk that you are embracing with any new investment. In other words, you might be jumping out of the frying pan and into the fire. Much like the damsel, we are better off if we are attentive to our options and the process and reasoning we use to choose a new investment, if that is, in fact, the best decision.
I think most of us have experienced intuition, where we have no rational or logical way to explain the fact that we accurately anticipated the outcome of an event, including what someone might say. I would argue that accurately anticipating what someone else might say is tantamount to knowing what is playing out in someone else’s mind. While we might be tempted to interpret that as actually having read someone else’s mind, this is where I would call upon another favorite principle of mine: the fact that you are unable to articulate a rational explanation for something, including what led you to make a particular decision, doesn’t mean that there is no rational explanation at all, and it also doesn’t mean that your brain didn’t go through a rational process. In other words, accurately anticipating what someone else might say is not necessarily proof that you have read his/her mind—a wholly irrational explanation.
Our brains are pretty phenomenal—yes, they can be pretty scary, too, but let’s try to stay positive. Our brains are so phenomenal that parts of them automate sophisticated processes in our body (e.g., regulating the pace of our hearts beating), while other parts simultaneously allow us to engage in amazing activities, like contemplating complicated, abstract ideas surrounding investing. In case you don’t think this is phenomenal, then go ahead and tell me exactly how fast your heart should beat for any given situation.
I'll wait.
Chances are that you are unable to fulfill the request for calculating a precise heart rate for any given situation. I don’t know about you, but I would consider such an explanation to demand intricate and specialized knowledge that most don’t possess—otherwise, most would be able to produce an explanation. Even though you can’t explain it, your heart continues to beat at a sufficient pace to provide the rest of your body with what it needs to survive, does it not? Hint: the fact that you are reading this means that the correct answer is yes.
If our brains are capable of regulating our heart rate and we can’t even explain how that process works, then does it not stand to reason that there are other processes, including some in the abstract realm, that our brains fulfill without us even being aware? Absolutely. What this means is that when it comes to anticipating what someone else might say, regardless of how much, or how little, thought we think actually went into it, there is information being processed that clues us into what is going on.
The natural extension of this is that the more information we have, and the better we understand it, the better our decisions can be that pertain to the circumstances we are facing.
Failing to Acknowledge Risk Does Not Mean there is No Risk
There are numerous ways that investment risk can be defined and measured. Two quick examples: beta and standard deviation. The conventional methods of defining and measuring risk, like beta and standard deviation, can be calculated for any investment that has existed for any period of time. Obviously, the more time involved, the more information you have, and the more reliable the risk calculations stand to be.
Even if a brand-new type of investment appeared on the scene, a proxy for the risk involved could be developed based on the details of the new investment. This is not too dissimilar from the concept of determining a listing price for your home based on the recent sale of comparable homes in your area. Regardless of how similar we might think one investment is to another, however, the fact that an investment is new means that it is safer to assume that the new investment poses more risk than that to which we might compare it. In other words, it would probably be best to assume that the risk of the new investment is actually some multiple greater than an existing investment that we think is comparable.
The reason why this is important has to do with the investment-divestment discussion above. Instead of approaching decisions to invest and divest from two different perspectives, investing should always be viewed as an act based on the potential for risk and reward that is informed by the best information available. If uncertainty is one way of defining risk, then failing to understand the investment you are running toward, when you seek to run away from another investment, does not help address the real problem at hand, which is a flawed risk-rewardperspective.
The Cognitive Dissonance of the Emotional Investor
It is an excellent example of cognitive dissonance for someone to simultaneously lament opportunity cost(s) and invest in something that presents a flawed risk-reward profile. After all, lamenting opportunity cost(s) stems from a want/need to have more money. A loss obviously does not get you more money, so if you load up on risk, you are potentially exposing yourself to a greater potential for loss than gain.
As it happens, Bob’s friend is potentially a good example of someone afflicted with this cognitive dissonance. Bob explained to me that his friend had invested the money he had in the bank in a “hedge fund” of sorts involving credit default swaps (CDS). For those who are unfamiliar, CDS played a central role in the financial crisis that led to the Great Recession, including the failures of Bear Stearns and Lehman Brothers. Suffice it to say that recent history dictates that there is a fair amount of risk to be had in CDS, and a weakening economy, like what data seem to explain we are currently experiencing, might be just the thing needed to prove that significant risk remains.
But hey, this strategy has the potential for incredible returns each and every year or so says Bob’s friend. When hearing that kind of pitch, however, we need to keep at least a few things in mind. If a market-driven investment is capable of incredible returns, the most meaningful way to understand those returns would be by way of a calculated average. If we’re dealing with an average, then that means that some returns will be greater and some will be lower—i.e., there would be a definite measure of inconsistency, also known as volatility. All market-driven investments come with their own volatility, and the riskier the investment, the more an investor should anticipate volatility and inconsistency.
Bob went on to explain that his friend told him that he (Bob) “ought to invest” some of his own money in the same way. Fortunately, Bob is pretty savvy and more than capable of making up his own mind, without being caught up in the urgency of a friend advocating for a certain action. Unfortunately, though, the same cannot be said for everyone, and I’ve certainly dealt with this kind of thing from time to time.
The Advocate
One person (we’ll call him the advocate) urging another to do something is really an interesting phenomenon. After all, the advocate typically does not benefit directly from the action at hand, nor would he suffer from a realization of any risk (loss)—i.e., the advocate doesn’t have any skin in the game. Further, my experience also tells me that the action being pushed is routine action that an advocate has already taken. Kind of makes you wonder whether that person advocates for things that they have not undertaken, themselves. These things are certainly true of Bob’s situation.
One of the most interesting aspects about these kinds of situations, though, is that I have never heard of an advocate taking the time to evaluate the needs (and maybe even risk tolerance) of the person to whom they are proselytizing. To look at it another way, he doesn’t take the time to understand just how similar his situation is to that of the other person, nor does he take the time to understand just how similar the other person’s thought process is to his own. It’s almost as if he just assumes that he is talking to himself—i.e., the advocate is projecting.
So, why the heck does this happen? I suppose someone could try to argue that it’s because the advocate cares, but is part of caring not understanding? In other words, taking time to understand the other person’s circumstances, including his/her thought process. It would seem that truly caring about someone else would include consideration of the fact that you might be wrong, and the other person might be harmed by following your advice. Given that, I would argue that the factor that best explains this type of “advocacy” is an oversimplified sentiment of social capital.
Social Capital
We all love to be right—don’t you dare try to claim that doesn’t apply to you because I will call you a liar to your face (just let me know if you’d rather I do it behind your back). Further, we love to receive credit for being right. In summation, we love offering advice, having someone act on that advice, and receiving the benefits and prestige that come from having given advice from which someone else benefited. That is social capital, which ensures that others will turn to us in the future.
Why? Well, being social creatures, it means that our connections to others are predicated upon social hierarchies. While that might seem like a difficult concept, it really isn’t. The simplest way to understand it is to think about situations you have faced where you sought out the advice of someone else. When advice was needed, chances are that you didn’t select someone at random to help you. Most likely, someone specific came to mind with whom you wanted to consult. That person, whoever he/she is, sits atop your social hierarchy, at least as far as a particular issue is concerned, and they have hopefully claimed that spot for good reason.
Regardless of whether you have an extensive network of friends that affords you a diverse group of folks with a diverse wealth of knowledge and experience, or if you just have one person that you go to for everything, the fact remains that someone has most likely ascended to a position of trust for you. This means they sit atop at least one hierarchy for you.
To possess the desire to sit atop the hierarchies of others seems to be the default, and I’m sure we all know someone who acts as if he/she wants to sit atop every hierarchy for every person, ever. We shouldn’t mistake anything about the motivations of others as necessarily nefarious, however. Sitting atop a hierarchy and being someone’s confidant is simply confirmation that you have value. Who doesn’t want to be valued?
Being a confidant, however, would seem to hold the potential to be pretty exhausting, depending on how much you are called upon or involve yourself, but there are benefits that potentially explain why we would be agreeable to such a role. The main benefit is the deference given to you by others. Simply put, with deference comes control, and if there’s one thing life has taught me, it’s that uncertainty is the enemy of the average person. Control, whether real or imagined, is how we mitigate uncertainty.
Not all confidants are deserving, though, and the problems associated with an inadequate confidant would seem to be limitless. The reason why a confidant would be insufficient would seem to come from one place: false confidence, either on the part of the confidant or yours. In other words, whether it be that we don’t really appreciate or understand what the other person is dealing with or what his/her thought process is, we’re willing to offer advice because we think we know enough. Further, the more confident that we are that we know all we need to know, and/or the more we desire to sit atop a hierarchy, the greater the passion behind our advocacy would seem to be.
If we do possess false confidence, though, then this would mean that we run the risk of missing the mark with any solution we prescribe. The specific reason why the solution might miss the mark, however, is because we have, first, missed the mark in defining the problem at hand. That is precisely where the utmost care must be used to ensure a proper perspective, and this is why we must seek to understand.
Needless to say, if financial decisions are made with false confidence, there can be some pretty drastic and severe consequences. Fundamentally, this is why an advisor must always seek to understand, first. He/she must listen and, if he/she is qualified to be your advocate and confidant, then he/she should also possess the knowledge and experience to function accordingly. This would include stepping in to educate when a decision to invest is driven more by the fear and haste behind a decision to divest.