March 23, 2017
by Dr. Wilson Chen, BSc., DDS, CFP, FMA
Humans are emotional beings. They have survived and thrived through the centuries by trusting their gut instincts, regardless of the prevailing logic. These deep-rooted behaviours have helped in many instances but have also become a burden in important situations. The field of behavioural finance was developed in the early 1970’s to try and explain why investors were continually making illogical choices. Through the pioneering work of Daniel Kahneman and Amos Tversky, we have a better understanding of what makes an investor tick. When it comes to investing for the long term, humans have developed mental biases that are irrational and, in many cases, detrimental. Let’s highlight four common mental biases that keep investors (dentists or otherwise) from reaching their retirement goals.
“Buy low, sell high”. It sounds so easy, doesn’t it. But it is so hard to do.
In our minds, we tend to weigh the most recent events as the most important. Hence the saying – What have you done for me lately? When you apply recency bias through an investment lens, investors will always look to sectors that are performing well and believe that this trend will continue. For those who remember the dot com meltdown in 2000, it was a classic example of recency bias. Technology stocks (especially those that were internet related), moved higher and higher in the late 1990’s. Many of these companies did not have any earnings nor any great ideas. Investors became more anxious as each day passed, as they felt that this rally would keep running and they would be left behind.
In many instances, investors sold out of their diversified holdings and dove into tech stocks – in effect, selling low and buying high – or the complete opposite of what we all strive for. When the bubble burst in March of 2000, many found that they had jumped in near the peak and participated only in the fall.
Even with history as a guide, many still can’t help dumping out of favour holdings to chase after recent winners. More often than not, it doesn’t end well.
Paralysis by Analysis
Katie is a young dentist who is starting to invest for the future. She is an admitted perfectionist which is what makes her such a good clinician. At first, Katie was enthusiastic about researching the various investment choices and was astounded by the number of conflicting products and strategies. She doesn’t want to make a wrong decision. Katie now regrets starting this exercise and hasn’t looked at it for the past three months.
Dentists, by nature, are perfectionists. They are wired to gather and analyze all available data to make a logical decision, and they expect a good outcome. Unfortunately, stock markets do not follow neat, predictable patterns and it is hard to come up with a definitive judgement. In the past, stock and bond investments have done very well over time, but in the short term, investments tend to fluctuate up and down. This uncertainty makes the dental investor nervous. What if there is a better choice out there? What if I make a mistake? When faced with uncertainty, the solution for many is to stand on the sidelines and do nothing – which could be the worst thing for your portfolio.
Our ancestors survived by putting more value on minimizing losses than achieving gains. Certainly, if you lose something valuable, like a food source, it could mean the difference between life and death. Over time, this bias has been ingrained in our psyche. For most investors, the pain of a loss is significantly greater than the pleasure of a gain.
Let’s put this another way. Jocelyn is a dentist with a good quality, well diversified investment portfolio. But hidden from view, she holds a handful of dreadful stocks that have lost virtually all of their initial value. She watched these shares decline over the years but could never pull the trigger to sell them. Rather than cutting her losses and moving on, she was waiting (hoping) for them to pop back up to at least their initial price. This way, she would not have to cement the loss and admit that she made a mistake. Unfortunately, the losses incurred by the underperformers have seriously diminished the gains from the rest of her investments.
Jay and Janice are diligent savers. Their goal is to pay off their mortgage as quickly as possible, so they set aside a portion of their income every month for this. In June, they found out that there was a mistake in calculating their income tax. Instead of owing taxes, they received a $10,000 income tax refund. Their goal of paying down the mortgage remains the same, but they used the refund to buy a hot tub and a big screen TV.
This is a prime example of mental accounting where people separate their money into different compartments. Since the income tax refund was unexpected and did not fall in the regular income category – it was easy for Jay and Janice to mentally spend the windfall. In the same vein, people will carry credit card debt with a 20% interest rate while saving money in a GIC for 1.5%. Two different compartments with no communication between the two.
For many of us, there is a constant fight in our heads between our emotional biases and our long term financial goals. By identifying the common biases, we are one step closer to resolving the turmoil and creating a clearer path to a consistent investment process. Hopefully, it will make us all better, and happier, investors.
About the Author
Dr. Wilson Chen, BSc., DDS, CFP, FMA received his DDS from Western University in 1992 and over the past 23 years, has built a patient-centered, family practice in Hamilton. In 2014, he sold his practice to take a more active financial management and business advisory role for his dental clients and their families. Wilson is the only practicing dentist in Ontario to hold the Certified Financial Planner (CFP) and Financial Management Advisor (FMA) designations. Wilson can be reached at firstname.lastname@example.org.
Dr. Wilson Chen is a Financial Advisor with Raymond James Ltd. The views of the author do not necessarily reflect those of Raymond James. This article is for information only. Raymond James Ltd. member of Canadian Investor Protection Fund.
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