“The investor’s chief problem—even his worst enemy—is likely himself.” So wrote Benjamin Graham, the father of modern investment analysis.
With these words, written in 1949, Graham acknowledged the reality that investors are human. Though he had written an 800-page book on techniques to analyze stocks and bonds, Graham understood that investing is as much about human psychology as it is about numerical analysis.
In the decades since Graham’s passing, an entire field has emerged at the intersection of psychology and finance. Known as behavioral finance, its pioneers include Daniel Kahneman, Amos Tversky and Richard Thaler. Together, they and their peers have identified countless human foibles that interfere with our ability to make good financial decisions. These include hindsight bias, recency bias and overconfidence, among others. On my bookshelf, I have at least as many volumes on behavioral finance as I do on pure financial analysis, so I certainly put stock in these ideas.
At the same time, I think we’re being too hard on ourselves when we lay all of these biases at our feet. A better way to think about it, I believe, is not to conclude that we’re deficient because we’re so susceptible biases. Yes, there’s a disconnect in how human beings respond to money and markets, but that’s because we’re simply looking at it the wrong way. The problem is that finance isn’t a scientific field like math or physics. At best, it’s like chaos theory. That is to say, there is some underlying logic, but it’s usually so hard to observe and understand that it might as well be random.
I say this not to disparage the field, but rather to help explain this disconnect. The problem, as I see it, is as much about humans’ inability to act rationally as it is about the world of personal finance being so full of paradoxes that no individual—no matter how rational—would be able to make optimal decisions.
As we head into a new year, and you plan for your financial future, I think it’s useful to be cognizant of these paradoxes. While there’s nothing we can do to control or to change them, there is value in being aware of them so we can approach them with the right tools and the right mindset.
Below are just a few of the paradoxes that can bedevil financial decision-making:
There’s the paradox that all of the greatest fortunes—Carnegie, Rockefeller, Buffett, Gates—have been made by owning just one stock. And yet the best advice for individual investors is to do the opposite: to own broadly-diversified index funds.
There’s the paradox that we make plans based on our understanding of the rules, and yet Congress can, and does, change the rules on us at any time, as they did just a few weeks ago.
There’s the paradox that we base our plans on historical averages (average stock market returns, average interest rates, average inflation rates, and so on), and yet we only have one life to live, and none of us will experience the average.
There’s the paradox that we continue to be attracted to the prestige of high-cost colleges, even though a rational analysis, based on return on investment, reveals that lower-cost state schools are usually the better bet.
There’s the paradox that retirees’ worst fear is outliving their money, and yet few choose the financial product that is purpose-built to solve that problem: the single-premium immediate annuity.
How should you respond to these paradoxes? As I noted, there is no silver bullet. But I think there’s a lot of value in simply being aware of them. As you plan for your financial future, embrace the concept of “loosely-held views.” In other words, make financial plans, but continuously update your views, question your assumptions and rethink your priorities.