Dining Room Economics
My in-laws are wonderful people from several perspectives. They welcomed me into the family 39 years ago, raised eight children and are now comfortably retired following a lifetime of saving and investing. I am in no way surprised that they have been successful investors as they began teaching practical lessons in behavioral economics right at the dining room table.
Behavioral economics, you may remember, is the study of why people - regardless of their education or sophistication - sometimes make less than optimum financial decisions.
The past eighteen months have given us an perfect example of behavioral economics at work, albeit one that I certainly hope isn't repeated anytime soon. Although none of our clients chose to take their money out of the markets during the recent correction, several of them called asking for reassurance that remaining invested was truly in their best interests. Other individuals with whom I spoke had chosen to withdraw from the markets and they too wanted confirmation that they had made a good decision.
Investment management firms like Warren Ward Associates are staffed by human beings who are in no way immune from experiencing fear. However, our clients depend on us to process that fear very carefully before responding to it. In the case of both the 2000 and 2008/9 corrections, we avoided making a fear-based decision to sell. We kept our clients in the markets, thus allowing them to participate in the subsequent upturns.
The decision to sell stocks and bonds (i.e. leave the market) necessarily involves two different steps. First - obviously - is choosing the right time to sell. As fear levels increase, people are more likely to take that step. When fear reaches the point that the idea of actually taking a loss becomes more appealing than worrying about how much more might be lost, they act. Once that happens, investors face the second decision: when should the money be returned to the markets? A fairly common answer is "when things look better" but using that rationale guarantees that the investor will have sold low and bought high (or at least higher). This is one of the very few life situations in which generally rational people resist buying things which have gone "on sale".
Such apparently irrational decisions led researchers to study behavioral finance. A very simple example involves two people being asked to play the "ultimatum game". The players are known as the proposer and the responder and each starts with no money. The proposer is given a sum of money to be shared with the responder in the proportions of his or her choice. However, neither gets any money unless the split is agreed to by the responder. Logic would suggest that any split would be a good one since, regardless of the percentage the responder might receive, it is greater than nothing. As the game is played, however, it is common for the responder to reject any offer very far from 50:50, even though such rejection means that neither player gets any money. Whether that response is driven by a sense of fairness or the same fear of loss that makes people decide to sell investments below cost, the most common response isn't a rational one.
By standing between investors and their investment decisions, planners can ask their clients to pause and reconsider their fear-driven urges, encourage them to take the longer view and try to help them achieve better long-term results.
Incidentally, in case you were wondering about my in-laws' dining room lesson, it was really quite simple. The family rule was that one child got to cut the dessert, then another choose the first piece. Behavioral economics at its most basic level.
Behavioral economics, you may remember, is the study of why people - regardless of their education or sophistication - sometimes make less than optimum financial decisions.
The past eighteen months have given us an perfect example of behavioral economics at work, albeit one that I certainly hope isn't repeated anytime soon. Although none of our clients chose to take their money out of the markets during the recent correction, several of them called asking for reassurance that remaining invested was truly in their best interests. Other individuals with whom I spoke had chosen to withdraw from the markets and they too wanted confirmation that they had made a good decision.
Investment management firms like Warren Ward Associates are staffed by human beings who are in no way immune from experiencing fear. However, our clients depend on us to process that fear very carefully before responding to it. In the case of both the 2000 and 2008/9 corrections, we avoided making a fear-based decision to sell. We kept our clients in the markets, thus allowing them to participate in the subsequent upturns.
The decision to sell stocks and bonds (i.e. leave the market) necessarily involves two different steps. First - obviously - is choosing the right time to sell. As fear levels increase, people are more likely to take that step. When fear reaches the point that the idea of actually taking a loss becomes more appealing than worrying about how much more might be lost, they act. Once that happens, investors face the second decision: when should the money be returned to the markets? A fairly common answer is "when things look better" but using that rationale guarantees that the investor will have sold low and bought high (or at least higher). This is one of the very few life situations in which generally rational people resist buying things which have gone "on sale".
Such apparently irrational decisions led researchers to study behavioral finance. A very simple example involves two people being asked to play the "ultimatum game". The players are known as the proposer and the responder and each starts with no money. The proposer is given a sum of money to be shared with the responder in the proportions of his or her choice. However, neither gets any money unless the split is agreed to by the responder. Logic would suggest that any split would be a good one since, regardless of the percentage the responder might receive, it is greater than nothing. As the game is played, however, it is common for the responder to reject any offer very far from 50:50, even though such rejection means that neither player gets any money. Whether that response is driven by a sense of fairness or the same fear of loss that makes people decide to sell investments below cost, the most common response isn't a rational one.
By standing between investors and their investment decisions, planners can ask their clients to pause and reconsider their fear-driven urges, encourage them to take the longer view and try to help them achieve better long-term results.
Incidentally, in case you were wondering about my in-laws' dining room lesson, it was really quite simple. The family rule was that one child got to cut the dessert, then another choose the first piece. Behavioral economics at its most basic level.
What a Difference a Year Makes
Investments are rarely the most important thing in anyone's life, yet the 24/7/365 coverage of markets can make them seem so. Recent headlines suggest that people are becoming more optimistic about the economy, a significant contrast to the mood which permeated society last year around this time.
In mid-September of 2008, the venerable brokerage firm Merrill Lynch was forced to merge with Bank of America and investment bank Lehman Brothers was allowed to fail. The next day, the multi billion dollar Reserve Primary (money market) Fund, which owned nearly $800 million in Lehman bonds, endured a "run" on its assets. That forced bond sales which briefly took share values under $1.00, something that had never happened to a "retail" money market fund before. In response, the government began a series of almost unprecedented interventions in the day-to-day activities of the markets. Among other steps, it guaranteed the value of all money market funds to halt the run on the bond market. Although most of us prefer that the government keep its distance from our personal affairs, there were very few complaints about its actions, due to the general level of fear which affected the populace.
Today, people seem to be more confident in some sort of reasonable future. Stock and bond markets have rebounded significantly. President Obama spoke of "green shoots" and, two weeks ago, Federal Reserve Chair Bernanke suggested that the recession was "very likely over". The Fed met last week and kept rates near zero, hoping to keep costs low for borrowers.
I think the term "mixed message" sums up the current year's situation fairly well. Our economy is certainly on the upswing. There is an improving market for stocks and real estate transaction are once again being completed. However, things are not back to normal yet. The stock market has risen on very little volume, suggesting that a significant selling trend would be difficult for the limited number of active buyers to absorb. Similarly, even though some areas of the country are enjoying a rebound in housing sales, portions of Florida, Nevada and California may face real estate illiquidity for years to come.
As I've said before, stock markets are leading indicators of an anticipated strengthening of the economy. The phrase "jobless recovery" often appears in the headlines during the early stages of an economic recovery. Unfortunately, such recoveries don't offer much help for home purchases, increased 401(k) investing or retail sales.
Dinah Washington's 1959 release What a Difference a Day Makes earned her a Grammy and provided me with a framework to approach this subject. The second verse of that song begins: "My yesterday was blue, dear, Today I'm a part of you, dear". If you will accept the substitution of year for day, you may agree that the song captures the change in mood from last year to this. While Dinah declares her love as "being a part of" someone else, all of us are part of our economy locally, nationally and globally. None of us will enjoy a sustained economic recovery until all of us have an opportunity to participate.
In managing money on behalf of our clients, Warren Ward Associates concentrates on the strategic allocation of their assets. Our aim is to use this diversification to do better during market pullbacks while generally matching the markets during upswings. We did not sell investments during the correction, so remain fully invested on our clients' behalf. We do expect to begin hedging some of their gains as the S&P moves above 1100 or so. Over-optimism isn't likely to be good for the long-term economic heath of our clients, regardless of how big a difference a year may have made.
In mid-September of 2008, the venerable brokerage firm Merrill Lynch was forced to merge with Bank of America and investment bank Lehman Brothers was allowed to fail. The next day, the multi billion dollar Reserve Primary (money market) Fund, which owned nearly $800 million in Lehman bonds, endured a "run" on its assets. That forced bond sales which briefly took share values under $1.00, something that had never happened to a "retail" money market fund before. In response, the government began a series of almost unprecedented interventions in the day-to-day activities of the markets. Among other steps, it guaranteed the value of all money market funds to halt the run on the bond market. Although most of us prefer that the government keep its distance from our personal affairs, there were very few complaints about its actions, due to the general level of fear which affected the populace.
Today, people seem to be more confident in some sort of reasonable future. Stock and bond markets have rebounded significantly. President Obama spoke of "green shoots" and, two weeks ago, Federal Reserve Chair Bernanke suggested that the recession was "very likely over". The Fed met last week and kept rates near zero, hoping to keep costs low for borrowers.
I think the term "mixed message" sums up the current year's situation fairly well. Our economy is certainly on the upswing. There is an improving market for stocks and real estate transaction are once again being completed. However, things are not back to normal yet. The stock market has risen on very little volume, suggesting that a significant selling trend would be difficult for the limited number of active buyers to absorb. Similarly, even though some areas of the country are enjoying a rebound in housing sales, portions of Florida, Nevada and California may face real estate illiquidity for years to come.
As I've said before, stock markets are leading indicators of an anticipated strengthening of the economy. The phrase "jobless recovery" often appears in the headlines during the early stages of an economic recovery. Unfortunately, such recoveries don't offer much help for home purchases, increased 401(k) investing or retail sales.
Dinah Washington's 1959 release What a Difference a Day Makes earned her a Grammy and provided me with a framework to approach this subject. The second verse of that song begins: "My yesterday was blue, dear, Today I'm a part of you, dear". If you will accept the substitution of year for day, you may agree that the song captures the change in mood from last year to this. While Dinah declares her love as "being a part of" someone else, all of us are part of our economy locally, nationally and globally. None of us will enjoy a sustained economic recovery until all of us have an opportunity to participate.
In managing money on behalf of our clients, Warren Ward Associates concentrates on the strategic allocation of their assets. Our aim is to use this diversification to do better during market pullbacks while generally matching the markets during upswings. We did not sell investments during the correction, so remain fully invested on our clients' behalf. We do expect to begin hedging some of their gains as the S&P moves above 1100 or so. Over-optimism isn't likely to be good for the long-term economic heath of our clients, regardless of how big a difference a year may have made.
