Behavioral Investing: Why Smart Seniors Make Stupid Mistakes with Their Money

In the Great Depression of the1930s, much like the severe economic downturn of 2008, market technician Ralph Nelson Elliott made an interesting discovery. He noticed equity markets move in similar and replicating patterns with degrees of trend. This new field, called Socionomics, explained market movements’ response to the prevailing social mood: euphoria and discouragement, optimism and pessimism. In fact, Robert Prechter, who recently popularized this area, warned of a top in the market in 2000 based on past patterns of market movement, in turn based on social mood. This major mood swing, called a Grand Supercycle, portends the magnitude of what may happen in a future framework without predicting week-by-week changes. This concept can be likened to a TV meteorologist who is able to warn of incoming storms a week from now based on his or her assessment of low-pressure areas, yet they may not be able to pinpoint the precise day next week the storm will occur.

A more important part of this grand market movement is how your clients emotionally respond to these seismic financial changes. It is widely thought that we are in a secular bear market due to the levels of debt incurred by the current administration. This treasury debt is competing with private debt, dampening the ability of private capital to influence future investment growth. Yet despite this evidence, many seniors believe we are in a bull market recovery. Even in that were true, it would be a very shallow recovery with a great deal of volatility in the short term. If your clients are caught on the wrong side of that volatility, it will greatly impact their retirement lifestyles. Here are a few of the traps your senior clients may find themselves in without the benefit of your financial guidance and counsel. As you read each of these objections and concerns from your clients and prospects, let them know first what the concept is and, if possible, relate anecdotes about other clients who have mistakenly believed similar notions and how you helped them.

The Objection: “I want to stay with my current advisor (even though I have lost 42 percent of my life savings over the last year).

This stupid investment mistake is called status quo bias.

To illustrate this mistake, consider an experiment performed by William Samuelson of Boston University. He showed clients three investment options: one stock with a 50 percent chance of staying the same, another stock with a 40 percent chance of staying the same, and finally, a U.S. treasury with a 9 percent return combined with and municipal bond with a 6 percent tax-free return. Which to choose? Forty-seven percent of those who were told they already owned an investment ignored their selection and remained with the investment they already had. This study showed that people are inclined to stay with what they have no matter how bad the performance. This also explains why some seniors will stay with a bad advisor.

The Fix: Tell your prospects about this research and also relate a story about a client who realized this mistake and how well they did by working with you.

The Objection: “I want to keep my money where it is. If I sell now, I will ink those losses.”

This stupid investment mistake is known as the sunk-cost fallacy — essentially throwing good money after bad.

These seniors believe their portfolio is still OK until they cash in. You can’t make changes to the portfolio because it will ink your loss instead of taking the money out and moving into a more sound investment. In the last decade, the Big Dig in Boston linking the city to Logan Airport was $15 billion over budget. The administrators wouldn’t fire the contractor and start over because of all the money they had already sunk into the project. Yet even after completion, a tile fell off the ceiling of a tunnel and killed a woman, causing the project to incur even more expense.

Similarly, the U.S. government gave $70 billion to General Motors in 2008. GM asked for $30 billion more in March of 2009. Both the Bush and Obama administrations fell into the trap of believing the company was too big to fail, but the ensuing GM default was the biggest sunk-cost mistake in U.S. history. If GM had restructured in September of 2008, they could have saved the company billions in costs and spared the U.S. taxpayer nearly $100 billion. Yet because of the inability to recognize sunk-cost fallacy, every citizen in America currently owes $600 per person on behalf of that one company. That is a sunk-cost sinkhole!

The Fix: Ask your client if they didn’t already own their investment, would they buy it again? A bold question like that typically will bring them back to reality quickly.

The Objection: “I am going to keep my money in the market. It is moving up and I want to recover my losses.”

This stupid investment mistake is called confirmation bias.

Seniors have a great tendency to look for information that confirms their beliefs, rather than data that falsifies it. To wit, consider Cornell marketing professor Ed Russo’s project of having students evaluate restaurants. They rated restaurants on a scale of one to 10, with 10 being the most positive. The ratings were based on menus and photos, but when the differences were mentioned one at time with photos of problem areas like rips in the booths and dirty kitchens, the students stayed with the initial ratings. They discounted information that didn’t fit with their first impressions.

Yet another example to share with your senior clients: Dick Winnick and Rahul Guah of Cornerstone Research in Boston noted that when consumers bought the same make of car every three to five years, they paid a premium over those who chose a different brand. Buick lovers paid an extra $1,500 and Mercedes owners paid an extra $7,500 due to the confirmation bias. Ultimately, these car owners tended to be less skeptical about and less willing to negotiate a deal with a brand of car they have owned for the last 20 years.

The Fix: Tell your clients about the dangers of confirmation bias and talk about information that refutes their views. Then produce stories about other clients who came to you with the wrong ideas only to succeed as a result of following your advice.

The Objection: “I don’t like totally safe investments right now. I am getting back in. Look at how much the market has gained!”

This stupid investment mistake is called short-term memory syndrome.

We soon forget what happened last quarter in favor of what happened last week. The stock market lost 42 percent over the last six months but came back 25 percent in the last six weeks. Therefore, some people think, the downturn must be over and boom times are here again. The stock market is based on earnings and GDP expansion. Everything else is sensitive to emotion and subject to volatility. This is also called “chasing returns.” There is a strong tendency for your prospects and clients to respond to news reports that tout something that happened today or this week while ignoring the longer term perspective.

The Fix: Talk to your seniors about the “Rule of 100.” Discuss the level of volatility over the last two recessions if they had been fully invested without regard to their retirement horizon. Again, it’s helpful to share stories about seniors you have helped weather the last few storms.

The Objection: “Losses are only paper; it’ll be fine eventually. I don’t really care about losses right now.”

This stupid investment mistake is called mental accounting. In this situation, people believe the money they have is worth the same no matter how they made it.

Some dollars are worth less than others and thus don’t matter. The notion is that my earned income is worth more than the money I make or lose from investing. This is where the idea of “found money” came from.

Gambling is a good example of this kind of thinking. One new husband, while waiting for his wife to dress before dinner, decided to try his luck with $10 at a Las Vegas casino roulette table. Ten dollars turned into $100. That became $10,00 and was soon parlayed into $10,000. But he lost it all on his last roll. On the way back to his hotel room, he noticed there was $5 left in his pocket. When his wife asked about his luck, he said, “Not bad; I only lost $5.” Casinos always make money.  Even Las Vegas hotel mogul Steve Wynn once said he has never seen a gambler make money over the long term.

The Fix: Take out a $10 bill and give it to your prospect. Let them keep it long enough to feel like they own it. Then ask for $10 out of their wallet and tear it up. Ask which $10 was a gift and which was earned. Believe me, they will quickly understand your point (but you might want to give them another $10).

Kerry Johnson

About Kerry Johnson

Kerry Johnson, MBA, Ph.D. is the best-selling author of seven books including his newest, “Behavioral Investing: Why smart people make dumb mistakes with their money (available at Peak Performance Coaching (his one-on-one coaching program) promises to increase your business by 80 percent in eight weeks. To see if you are a candidate for this fast-track system, click on
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