This week we welcome Mike Piper, the blogger behind ObviousInvestor.com and the author of several books, including his latest, Microeconomics Made Simple. Below, Mike shares his suggestions from preventing your emotions from getting in the way of your financial success.
Behavioral economics is the study of how our emotions, cognitive biases, and other psychological factors affect our financial (and other) decisions.
For example, when it comes to investing, research from Morningstar shows that investors actually tend to underperform their own mutual funds by moving money between them at inopportune times. That is, we typically do a decent job at picking mutual funds, but our emotions get in the way when it comes to sticking with those funds. Fear, greed, and impatience get the better of us, causing us to abandon our funds after periods of poor performance (which even the best funds will have from time to time).
So, as investors, what might we do to overcome the temptation to fiddle with our portfolios?
Consider this: If you’re trying to cut back on ice cream consumption, what do you do? Do you keep a freezer full of ice cream, and simply try everyday to fight the temptation to eat it? Of course not. It’s easier and more effective to remove the circumstances that tempt you — just stop buying ice cream.
I’ve tried to implement a similar strategy with my investment portfolio. Previously, I used a portfolio with a handful of different index funds. But every time I logged in to make an IRA or 401(k) contribution or to rebalance my holdings, I would be tempted to change something (e.g., adjust my stock-vs-bond allocation or my domestic-vs-international allocation). And these are exactly the types of temptations that typically lead investors to underperform their own funds.
So, a couple of years ago, I decided to remove the temptation. I switched everything over to a single mutual fund that holds a complete, diversified portfolio of domestic and international stocks and bonds. (Specifically, I use Vanguard’s LifeStrategy Growth Fund, but a low-cost target date fund could perform a similar role.) Now, I’m no longer tempted.
Instead, my retirement accounts function much like a savings account, just with much more risk and higher expected returns. They require no maintenance, and whenever I make contributions, I don’t have to think about it — every dollar simply goes into that one fund.
Of course, this isn’t a good solution for everybody. For example, all-in-one funds are generally tax-inefficient, making them a poor fit for taxable accounts (as opposed to retirement accounts). And some investors want a specific allocation that cannot be achieved with a simple all-in-one fund.
In addition, as behavioral economist Meir Statman points out in his book What Investors Really Want, some investors derive a significant amount of entertainment value from actively managing their portfolios — whether that means researching stocks, trying to pick outperforming funds, or something else. For investors who derive “utility” (economics-speak for happiness) from such activities, a boring passive portfolio may not be the best choice, even if it’s the choice most likely to give the best results.
I’m not one of those investors. For me, managing my portfolio isn’t my idea of a good time. I’d rather not have to think about it, not have to do any maintenance, and still achieve a respectable result.