Know Thyself

Photo credit: coop

This ancient two-word phrase, attributed to several Greek luminaries ranging from Socrates to Pythagoras, implores the reader toward introspection. This introspection can be especially helpful when considering how we feel about our financial future – particularly when we are at extremes of emotion.

The recent stock market activity has given us plenty of opportunities to experience extremes of emotion… but then again, you can pretty much choose any time period and make a similar statement. There are quite a few studies that have recently brought to the forefront several things that we need to understand about ourselves and how emotion could impact our decision-making process.

Loss Aversion – as investors in general, we feel the impact of a loss approximately twice as much as we experience the good feelings from a gain. It has further been estimated that as we approach retirement, this ratio increases to a factor of five times more pain for a loss as opposed to the joy we experience for a gain.

This seems to be true no matter whether the loss is realized or simply on paper. The problem is that, in stock market investing, short term losses and gains are simply normal market activity, and we need to temper our emotions to keep things in perspective.

We Want Control… or Do We? – it would seem to follow the train of thought that, if we are feeling pain in our investing activities we’d appreciate some guarantees and protection of some sort in our choices of products. However, guarantees come with a cost – that of giving up control. And as investors we prefer control (or the perception of control) over guarantees, studies have shown.

On the other hand, other studies tell us that a guaranteed income from an investment is preferred over an assured return on investment over time. These studies show that, given a choice between an annuity with a monthly income and an investment portfolio structured to provide the same sort of returns over time, if we’re near retirement we choose the annuity seven times out of ten.

This seems to imply that we value the concept of income, that of receiving a check every month, over the excess costs and lack of control that an annuity represents. At the same time, we prefer to feel like we’re in control of our investing activities, which is counter to the argument in favor of an annuity.

Lack of Understanding of the Numbers – when presented with the outcome of financial calculators, many of us consider whatever calculations were done in the background to be tantamount to magic. For example, the very concept of inflation and its impact on our future finances is a mystery to us – we work best when calculations are discounted to present values.

Even though it’s been decided that it was politically incorrect, one popular baby-boomer who is now age 63 once admitted that math is tough (Barbie, of the doll fame, who actually admitted that “Math class is tough”). There’s no shame in admitting that factor – for a lot of us, math can be very tough. And as we get older (some say by around age 53) our understanding of mathematical calculations begins to decline dramatically, making math even tougher.

This can lead to distrust of the very calculations that could help you make good decisions in your financial life.

So What Does All Of This Mean?

Mostly this just means that we’re carrying with us a lot of preconceived notions and emotional preferences that we must take into account as we make financial decisions. “Know Thyself” means that we should understand how these various notions can paint our perceptions of situations, and if we understand these things, we can recognize when our own limitations are working against us and take actions to consider things in a new, less biased, light.

For example, it’s natural to feel the pain of losses. But as explained in the article The Lost Decade and What It Means, (yes, it’s an oldy, but a goody) the activity of investing, especially in the stock markets, is a long-term activity and short-term losses, even over a few years, are temporary in the scheme of things. Keep this in mind before making any rash investment decisions – you’re likely to regret emotion-driven decisions.