Why We Care (or Don't) About Causes

It's unusual for me to post twice in a day, but I just saw this link posted by one of my colleagues, and it's an interesting piece on human behavior that I just had to share. Simply click on this blog title to go to the article.

Economics- Information or Buzz Kill?

Economics has been dubbed "the dismal science" (it's not a hard science like chemistry, but is lumped in with sociology and psychology). I suspect one of the reasons that it has this moniker is due to its basic definition: "the study of competing demands for scarce resources." Do you find that depressing, or at least, not very uplifing? To me, the concepts of competition and scarcity are trigger words (more about that in a moment).

Interestingly enough, the study of economics, during the past 20 years or so, has developed a sub-category called "behavioral finance." Economists study what is considered rational behavior (buy low, sell high, hold for the long term, maximize your economic benefit), but they have observed a lot of "irrational" behavior (which could be summarized as irrational exuberance and its dark cousin, terrified capitulation) and decided to study that scientifically as well. So, you could say that behavioral finance is the shadow side of classic economics.

In my opinion, a lot of the "irrational" behavior is quite explainable without requiring equations - it is a fear-based reaction to these concepts of competition and scarcity. In a more perfect world, we might recognize that competition and scarcity are human concepts, not reality. In that case, the fear would immediately lift, behavior around money would normalize, and life would be a lot different.

But this isn't a perfect world. And, although behavioral finance has been around for a while, very little of this knowledge has trickled down to the average citizen, who still is at the mercy of his or her fear-triggered irrational money behavior. Financial advisors are aware of these concepts, mutual fund managers try to use these concepts as portfolio management strategies, but the average citizen still has to cope with their uncomfortable feelings without any understanding.

A few years back, I developed a course for investors that discussed some of the most applicable concepts of behavioral finance and showed these individuals how to understand their behavior and avoid some of the bad decisions that would otherwise result from reacting to their instincts. It's a fascinating study, and once clients took this class, they were much more comfortable and patient investors, since they had tools to ease this discomfort. I have attached a preliminary flyer for this course, since it's high time that I teach it again; it will be re-cast as as series of teleconferences. So, watch for an announcement for Preparing to Invest Wisely!

The Difference Between Men and Women (again)

Ever since we were young children, we have been aware that boys (men) and girls (women) are different.

In my profession, you hear a lot about the difference between men and women in terms of investing behavior (men are bolder and take more risk, women are more nervous and take less risk). It's true that men will often, because of their bolder approach, make a few more investing mistakes than women, and women will often pass up better returns in favor of safety.

Well, it turns out that women and men have very different reactions to stress (and of course, none of us are experiencing that, lately). The common, universal belief was that the human reaction to stress is the famous "fight or flight" response. Hah! The studies leading to this conclusion were only done on males.

My friend Delia Fernandez (an advisor in Southern California) was preparing to give a speech to a women's group and dug up this interesting tidbit: About 10 years ago, a group of (women) researchers decided to study stress reactions in females. So they assembled a pack of female rats, and subjected them to stress (Delia did not tell me exactly how they stressed the lady rats). And, their reactions were completely different than male rats - rather than starting fights or huddling alone in the corner of the cage, the female rats sought out their friends and offspring, sharing a lot more affection and mutual grooming than usual, when they were experiencing the stress. The researchers, seeking an alternative terminology to the "fight or flight" description, dubbed this reaction "tend and befriend."

So, it's a normal reaction for a man to swear or hide out in his man-cave under stress, and ladies - that urge to call your girlfriends and go out for a pedicure when the going gets tough is your normal reaction to stress!

Letting Go

How often have you felt that you can't sell a stock or fund in your portfolio because its value is very depressed, and you keep thinking "I'm gonna wait until it's back at what I paid for it, and THEN I'll sell it and buy something else"? It's almost as though we think that holding owes us an apology for being such a pain.

Here's a little example that may expose the trap you have fallen into. First, suppose that you had logged onto Fandango (the on line movie ticket service) and bought a $10 ticket for a movie that you have been eager to see. You print it out and head to the movie theater. However, on the way from the parking lot at the mega-mall, you somehow lose your ticket. Are you going to be willing to fork over another $10 cash to see the movie? Or do you just turn around and go to Best Buy instead?

On the other hand, if you did not buy your ticket ahead of time, you may have gotten to the movie theater with the intention of paying cash for your ticket. When you get to the ticket seller, you see that there is $10 less in your wallet than you thought (although there is enough money to buy the ticket). Do you still go ahead and buy the ticket?

What is your reaction? A study shows that people are more likely to walk away if they had bought the ticket ahead of time, since they "already spent" the money. But, you have "lost" $10 regardless of the scenario. Due to a behavioral quirk called "mental accounting" you believe that the money already spent on the ticket is more "lost" because you used it to buy something concrete, than the $10 shortfall in your wallet.

In the stock/fund case, you have lost value due to that specific holding, and investors tend to believe that they must regain that loss before they can sell the holding and buy a replacement. However, here is a question to ask yourself: "If I had cash today and was evaluating investments, would I buy XYZ today?" The answer will probably be no. In that case, you should sell that investment and replace it with something better (in these days, sell the GM stock and buy Ford - this is not a recommendation but an example) right now. If you choose wisely you will recover your losses and then some. Don't make the original holding responsible for your investment satisfaction. As Peter Lynch once said "That stock doesn't know that you own it." If that's true, its purpose in life is not to make you happy or to do as you say!

Sleeping Through a Crisis (or not)

We remember the story of Rip Van Winkle, a ne'er do well fellow living in upstate New York just before the Revolutionary War, who played ninepins with some mysterious ghostly characters. He accepted a drink from them, and promptly fell asleep for twenty years; when he finally awoke, the world had changed drastically.

Well, suppose you had a tiny sip of this same stuff, say, on New Year's Eve, and you fell asleep and didn't wake up until this morning (May 30). Knowing that 2008 had been a bad year for the stock market, you dread opening up your May investment statement, or looking at your 401k balance, but much to your relief, you are actually a little higher than you were on December 30, 2008. "Well" you think to yourself,"that little nap was no big deal because obviously nothing went on while I was snug in bed."

As the attached graph shows, you actually missed a significant amount of drama! If only we could all go to sleep while bad things happened - we'd be much less inclined to "do something!!!!" Simply waiting out this turn in the market while wide awake, however, was nerve-wracking. And this just got us back to where we were at the end of the year.

Continue to watch with interest and curiosity as we continue down this path - it's up to you to take a nap or stay awake on the way.

Pat Is Back - After a Long Christmas Vacation

Gosh, I haven't posted anything since just before Christmas? Well, the first couple of months this year were scary, and through March 9, downright upsetting.

However, the market has lifted off of this bottom, with rallies interspersed with fallbacks and consolidation days. However, the market is simply now no longer on its butt, but on its knees. We have a long way to go before it is on its feet, steady, and marching forward (with occasional detours).

Much of this rally is a move away from the extreme pessimism we were experiencing; the bulk of the relief is come in the form of more detailed revelations of the actual workings of government programs. Banks performed better than expected in January and February, although the market did pull back today when those same banks indicated that March would not be as good.

I must re-iterate here that the market in the long run is a LEADING indicator. This means that it generally tends to point to where the economy will be in six to nine months. For the most part, you can get the impression that the market responds to news (good - up , bad - down), and in the short run it does indeed respond to news, especially surprises. But we could possibly now begin to think that this lift of the market off of the bottom may be telling us that the economy will start to lift off its bottom starting at the end of the year.

But, it's no use making too much of anything right now, as even the announced government programs have not begun to operate. It's too soon to make any statements about whether or not these programs will work (although there is no shortage of pundits out there who are ready with opinions). We want relief, and we want it now, and it's hard to wait for the results.

The Human and Non Human Face of Greed

Unless you live on another planet, by now you have heard about the Bernard Madoff scandal. Through his investment company, he lured trusting investors (including personal friends as well as high level banks and investment companies) into a Ponzi scheme that resulted in the loss of billions of dollars. Essentially a Ponzi scheme brings in investors, and then uses money coming in from subsequent investors to pay what appears to be returns to the early investors. Of course, this unravels because the only way this works is to keep expanding your base of new investors, and that is not possible since the number of human beings on this planet is finite.

What makes people invest in Ponzi schemes (or multi-level marketing, for that matter)? The lure of assured positive returns, no matter what. We have seen that this is not possible in all environments, but greed and fear can blind people - or at least, cause them to see only what they want to see.

This scandal puts a human face on false markets and false returns. I do believe that the last two bull-and-bear scenarios were also cooked up with false pretenses. The 1998-2000 bull market was fueled by insane expectations regarding the profits of high tech and Internet companies (many of whom had no real product that created actual economic value). When we finally looked to see where the money was, it wasn't where we thought it was (in the true value of the companies) and stock prices dropped as the assets were drastically re-valued. Many of those firms no longer exist (remember Pets.com and the sock dog puppet?). The 2003-2007 bull market was fueled by low interest rates and the housing boom, which drove financial institutions to "engineer" and sell securities backed by home mortgage debt; by the "engineering" I refer to the fact that these securities were then borrowed against, and the money created from the sales was used to purchase more of the same type of securities. So, theoretically, the same loan was sold 1o to 40 times. Again, when we looked to see if the money was there, it wasn't , since the financial engineering created a sort of technical Ponzi scheme. The money wasn't there, and the assets had to be revalued. This time, it wasn't just stocks, but home values, and even the viability of the banks and investment firms (some of which have gone out of business just like Pets.com) that plummeted, along with our confidence in "the system."

This may seem depressing, but we now have a chance to dust ourselves off, change our thinking, and figure out ways to help the economy recover through the creation of real value and growth. Perhaps after two "trickster" markets, during which we really didn't make any progress, we can now set aside greed and fear, and put some real thought into what we do going forward. I have appended an interesting chart to this rather long blog (making up for the lack of posts thus far) which illustrates two things: the two "false" markets, and the possibility that we have once again returned to reality with the chance to move forward with true growth.