Looking Past the Numbers: Behavioral Pitfalls in Investing, Part II
As I (finally) sit down to write my second piece on behavioral finance, I’m starkly reminded of my own behavioral shortfalls. In this instance, its procrastination, and I’ve always been guilty of it. My original plan was to write this piece two weeks ago and yet, here I am, staring at a blank page assuring my colleague that my contribution to the Investment Outlook will be ready by the end of the day. My point in sharing this with you is to show that changing behaviors is hard - even when you are vividly aware of your shortfall.
Mental Accounting is something we are all guilty of, no matter how aware of the problem we may be. Mental Accounting, at a basic level, is the act of walling off different segments of your assets so you don’t look at your overall wealth as one big picture, but as numerous smaller vessels. The problem with having different silos for different parts of your overall wealth is that it becomes nearly impossible to optimize the level of risk you are willing and able to take. As a result, your overall asset allocation may be a bit off.
Take, for example, the multi-millionaire that keeps $1 million in cash at a bank and has a balanced investment account worth $4 million. Let’s say the overall asset allocation of the investment account is 50% equity and 50% fixed income and cash. In this investor's head, they are likely thinking of the $4 million when they consider asset allocation, but shouldn’t the $1 million in safe assets at the bank be taken into consideration, too? By taking that additional $1 million into consideration, the overall asset allocation has changed from 50% / 50% to a more conservative 40% equity and 60% fixed income and cash. If this investor’s optimal asset allocation is 50% / 50%, they are doing themselves a disservice by being too conservative and likely don’t even realize they are doing it!
The example above is designed to be simple but think about how quickly this idea becomes complicated. Real estate, debt, business assets and the liquidity of each all must be taken into account when considering an overall risk profile for an investor.
Some common mental accounting mistakes we have seen over the years at Beese Fulmer include:
- Investors wanting to hold large amounts of cash in their investment portfolios while also holding large amounts of cash at a bank or in another safe savings vehicle.
- This results in the investor holding more, safe, low-yielding assets than they realized.
- Business owners that have a large share of their overall wealth tied up in their business wish to invest heavily in other public companies in the same industry.
- This results in the investor having far too much exposure to one industry.
- Investors not considering the present value of a pension or annuity they have as a fixed income asset.
- This results in the investor underestimating the allocation to fixed income or other safe assets.
- Investors with numerous real estate investments who want to own even more, and often very similar, real estate exposure through publicly traded REIT’s.
- This results in the investor having too much exposure to real estate.
- Investors that use leverage to make their overall asset allocation riskier than they may realize.
- This results in higher highs and lower lows, and an overall much more volatile risk profile.
The best way to overcome these mistakes is to understand and keep updated an overall snapshot of your total wealth. This can include everything from cash buried in the backyard, to business assets and monthly fixed payments that you receive. The key is to make sure that this snapshot is detailed enough to cover the vast majority of your wealth, without making it too burdensome to update regularly. By maintaining this snapshot of your total wealth, you are more likely to avoid the problems that go along with thinking of your assets in separate distinct buckets.