Investing - The Behavior Gap

If it's true that a picture is worth a thousand words, then I have a treat for you. At the annual Financial Planning Association conference in San Diego lost month, I spent some time with New York Times contributor, Carl Richards. He writes the Bucks Blog for The New York Times and has an upcoming book: The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money.

Though Richards insists that it's not art, he manages to illustrate points with some very simple diagrams that take me so much longer to get across with words. All of his diagrams explore the relationship between people and their money.

I knew I was going to like this guy when, upon introducing himself, he said "nice to meet a fellow trouble maker." Richards was kind enough to let me use some of his sketches, and here are a few of my favorites, with a bit of my own interpretation.

Knowledge or Feelings?
Jason Zweig noted that we have two brains: The reflexive brain, which acts on instincts (feelings) such as wanting that slice of artery-clogging pepperoni pizza. And the reflective brain, which acts on the knowledge gained by applying facts and logic.

In investing, it can be difficult to determine which brain is in the driver's seat. Take for example, jettisoning the stocks you bought earlier this year after the 20 percent off sale. Is it your logic telling you that this time it's different because of the global debt crisis, or is this your reflexive brain telling you that the sky is falling and causing you to repeat the cycle of buying high and selling low? Choose carefully.

Turn the page for "Slow and Steady"

Slow and Steady
I call this "Dare to Be Dull" investing. Sure, it feels good to be chasing the next Google like you're running with the bulls in Pamplona. Just as it feels good to believe that there is some psychic software app out there that can tell us when to buy and sell stocks like our brother-in-law claims to be doing. Unfortunately, the odds of this working over long periods of time are a bit worse than playing the lottery.

On the other hand, by taking the less endorphin-inducing path of minimizing expenses and emotions, and maximizing diversification and discipline, we will beat nearly all investors. Though we won't be able to brag about our exciting picks, we will be able to enjoy decades of compounding, while the brother-in-law may find himself spending his golden years under the golden arches asking "would you like this super-sized?"

Turn the page for "Investing and Entertainment"

Investing and Entertainment
This says very simply that investing shouldn't be fun. I've gone a step further by saying that if it feels good, you are probably doing something very wrong. To take it yet another step further, the best sign that you are doing something right is that it hurts, also known as "hurts so good investing."

In this down market, the prospect of bailing is immensely appealing. The prospect of rebalancing, however, and actually buying more stocks elicits the kind of pain I haven't felt since the last time I played flag football with players half my age. Guess which one I'm doing?

Turn the page for "Yields and Risk."

Bonds - Yield and Risk
In 2008, the average bond mutual fund lost about eight percent, just when we needed our bonds to act as our portfolio's shock absorber. I'm glad that I had high quality bonds like the Vanguard Total Bond Index Fund that earned a bit over five percent.

Fast forward only three years and people are again taking on more risk to get more yield, thinking it's just a little extra free return. This proves the behavioral finance theory that humans are not efficient learners.

With that said, there are some CDs that pay better than bonds and I do stash most of my fixed income in CDs, rather than bonds.

Turn the page for "money and happiness."

Money and Happiness
I'm fascinated with the subject of money and happiness, and the human tendency to think that buying stuff will make us happier, though it only works in the short-run. We love the new Lexus until we get that first dent. We love the big house until that first winter's utility bill comes or the deck needs replacing.

Getting off that hedonic treadmill is far more likely to make us happier than the stress that comes from being in debt and and knowing that you will be working for the rest of your life rather than doing what would truly make you happy.

Turn the page for "Jim Cramer."

Jim Cramer
Why mess with perfection? I have nothing to add here.

Turn the page to sum it up.

My friend Carl Richards has come up with something brilliant! I ask myself why I didn't come up with this concept, but that's the way I feel about all brilliant things I didn't think of.

I can't wait until January 3rd when his book is released. Until then, I may be spending a lot of time on his web site, behaviorgap.com, to get more.

More on MoneyWatch

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5 Dumbest Statements in Investing
"Hurts So Good Investing"
Investors: Ignore Your Instincts

Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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