7 Investing Lessons from Behavioral Psychology

Click … bait

You could start by not wasting your time clicking on stupid clickbait articles, I suppose. But since you’re here you might as well learn something.

Investing should be mainly about hard work, slogging through accounts and trying to figure out where or why a company has a defendable competitive advantage. But that’s not much help if you have the self control of an octogenarian with prostate trouble.  Investing is 90% hard work and 10% mental discipline – but don’t even bother if you haven’t got the 10%.

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Investing In Our Children

Live Long and Prosper

Statistically, a child born today is more likely to reach 100 than someone who is already 96 years old. And this is happening at a time when government resources are increasingly stretched and retirement ages are creeping upwards, when the populations of the developed nations are aging and the borders are increasingly closed to younger people from poorer countries.

As parents the one thing we can do for our children, to prepare them for this dystopian future, is give them the skills they need to survive and, hopefully, prosper. And chief of those skills, in a world dominated by the ideology we call capitalism, is a proper understanding of how to manage money: because the alternative is that money will manage them.

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Behavioral Resolutions for Behavioral Investors

Death or (um … ) Death

Apparently the ancient Babylonians would, at the start of each year, promise to pay off their debts and return stuff that they’d borrowed, like the lawnmower (or, as we would refer to it, the neighbor’s goat). As we saw in On Incentives, Agency and Aqueducts  they had good reason to be cautious as the punishment for theft was death. Although, to be fair, the punishment for everything in Ancient Babylonia was death. What they lacked in imagination they made up for in consistency.

These days we have less strict incentives to keep to our New Year Resolutions, but would probably find ourselves wealthier if we could stick to a few simple rules. The essence of being a psychologically aware investor is self-control, and what could be less modern and more ancient than that?

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Things Investors Should Hate 5/5: Themselves

We can blame many things for the state of our retirement savings plans – economists, bankers, politicians, the Chinese, globalization, sunspots, socialists, capitalists, journalists, investment analysts, financial advisors or even just bad luck.  But in the end the only person that’s really responsible is the one staring back at us in the mirror in the morning.

Personal responsibility is the adult basis for grown-up investing.  Unfortunately our infantile brains resist our every attempt to train them.

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Get Rich, Flee Temptation

Double Your Salary

Let’s say you were made an offer in return for giving up your favourite treat for a month: let’s say you were told you would double your monthly salary - forever - if you abstain from alcohol or coffee or heroin or whatever for just four weeks. Would you take this deal?

It’s a no-brainer, of course, which is why it’s exceedingly odd to discover that this exact deal is one that many of us are unable to make. Human lack of self control is a remarkable thing, but it’s made many times worse by financial services offers designed to lead us into temptation.

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The Secret of a Healthy, Wealthy Life

Infantile People

People, we know, generally aren’t very good with money. They don’t save enough, are inclined to procrastinate over saving for the distant future and are easily induced to splash out for instant gratification using the plastic. All of which has led psychologists and governments to start trying to use psychology to manipulate citizen’s behaviour in their own best interests.

Yet what’s interesting is that there is a small, but significant, group of people who overcome these problems with apparent ease. Not only are they better with money but they’re more likely to form lasting relationships, avoid criminal convictions and annoy everyone with their all round smugness. What’s even more interesting is that there’s a simple way of picking out these people from the age of four: and all you need is a couple of marshmallows.

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Deep Time and the Fallacy of Frequency

Ice Age 6?

There was a time when geologists reckoned that we’d never see another Ice Age. This was when our understanding stretched back only as far as the last one. Then they discovered that there’d been not one Ice Age, but five, stretching away back into countless hundreds of millions of years.

One-off events, even ones as apocalyptic as the general freezing of the world, tend to be ignored: but repetitive ones are viewed very differently. Things that have happened multiple times before may happen again: frequency changes perspectives. Unfortunately the geological view of Deep Time isn’t shared by investors, whose event horizons rarely reach beyond the next quarter.

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Putting Down the Credit Cards

Deviant Cards

Credit cards are one of the modern era’s great financial innovations, and have benefited the financial institutions that issue them terrifically. Unfortunately many of the people who use them get rather less rewards, mainly because of the unconscious biases that compel their every conscious move.

One of the few manifest and practical advantages of credit cards, though, is that analysis of their use is a practical primer in many of the behavioural biases which so entrance us on these pages and of the way in which ill-considered legislation magnifies their effects. Credit cards are a marvellous mechanism for a study of our deviant debt-laden ways and the ineptitude of our legislative representatives. However, they’re also the thin end of a very dangerous wedge.

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The Psychology of Dividends

Dividends Can’t Matter – Rationally

One of the more amusing failures of classical economics is its inability to explain why companies pay dividends. The Miller and Modigliani (1958, 1961) synthesis shows that rationally dividends are irrelevant to a corporation’s valuation: after all, if you give investors some of the company’s earnings then the company should be less wealthy to the same degree that investors are more, so there’s no net gain for shareholders.

Which is all nice and theoretically sound in the hermetically sealed world of rational economics but, unfortunately, when companies cut dividends their valuation usually drops, often quite dramatically, and when they raise them significantly the opposite happens. As usual, out in the real-world, it’s what people do, not what economics dictates, which rules.

Give and Take

The rational analysis of the irrelevance of dividends is perfectly grounded in straightforward economics. If I own a share which gives me access to $2 of a company’s earnings and the company gives me $1 directly then the company’s share price should drop by $1 and I will be $1 personally better off (minus taxes). So all things being equal a dividend should be irrelevant.

In fact dividends may well be damaging to a company’s prospects. If instead of giving me $1 the company invested it in product innovation, or marketing or an earnings enhancing acquisition (no laughing, please) it will be able to grow its earnings more quickly. I, the shareholder, benefit with a more rapidly increasing share price. If I want some of this for my own personal consumption I sell some stock.

Of course, large and mature companies may not be able to find sufficient earnings enhancing opportunities and so, all things still being equal, may decide that returning excess earnings to shareholders is the best thing. Again dividends aren’t the only way of doing this, although as we discussed in Buyback Brouhaha the main alternative – stock buybacks – is shrouded in managerial deceit and accounting opaqueness in a way that dividends aren’t. Although buybacks may be more tax efficient, depending on your taxation jurisdiction.

Dividend Signalling

So there are valid reasons for dividends, even if the classical view states that this won’t benefit shareholders directly. At least returning cash to shareholders allows us to redeploy these into other opportunities with better earnings prospects – although, as has often been pointed out, we can do that by selling one company’s shares and buying another’s.

Overall, then, it’s not at all obvious why companies should be overly concerned about dividends. However, they are, because they spend a great deal of effort manipulating dividends and giving indications about future dividend policy. And they’re right to do this because surprises in terms of dividends tend to cause significant share price movements in spite of what classical economics tells us should be the case. One of the possible explanations about why dividends persist in spite of economists saying they shouldn’t is their signalling effect.

So, a change in dividend policy may often indicate a change in the company’s fortunes. A cut in dividends will often signal reduced earnings – although it sometimes indicates that there are better earnings enhancing opportunities around. Similarly an unexpectedly raised dividend will often see a share price surge – even though this often indicates that the management have run out of ideas about how to deploy their spare cash, which isn’t exactly a positive sign.

Desperate Dividends

However, to argue that the only reason dividends exist is to give managements a way of showing their confidence or lack of seems, well, desperate. After all management could rather more simply tell us directly that they have low visibility of future earnings – they’ve been doing that rather a lot recently. No, the real explanation seems to be that investors often prefer dividends: so why might investors have a preference for higher taxed dividends over internally reinvested earnings?

Well, firstly, returning free cash to shareholders removes from management the temptation to waste it on pet projects. It also has the rather odd effect of disciplining managements because they will more often have to raise additional capital in the market. Strange though it is, companies that pay out dividends are often simultaneously tapping the markets for additional capital. That additional capital costs the company money in fees, dividends cost the shareholders money in taxes and the total result is a significant reduction in earnings available to the company’s owners.

We live in a strange world.

The Psychology of Dividends

There are also multiple behavioural reasons why investors might prefer dividend paying stocks over non-dividends. Firstly, receiving an income stream means that investors don’t need to sell stock to receive an income, which can often be a source of regret (which we discussed in … err … Regret) if the company subsequently does well. Of course, investors could have reinvested their dividends in the stock but this is a sin of omission, as opposed to a sin of commission, and is far more easily ignored, as suggested by Shefrin and Statman.

Secondly, the problem of self-control that we discussed in Retirees, Procrastinate at Your Peril is far easier to manage if investors decide to spend only their dividends. Although the research suggests quite strongly that the only stock market growth available for long periods is through dividend reinvestment investors will often spend the “interest” on their dividends anyway. By avoiding any sale of capital it’s easier to control the urge to spend the lot. This is Mental Accounting again, of course.

Finally there’s a case that a stock paying a high dividend today is perceived as a better bet than one that may provide greater earnings and price increases in future. This is known as the “bird-in-the-hand” fallacy.

Residual Dividend Policies

One of the odder findings in research on dividend paying stocks is that those companies which follow a so-called residual dividend policy – essentially paying out their entire free cashflow to investors as dividends – are generally more financially sound than companies paying out less of their earnings. Explaining this isn’t easy, but it’s possibly worth noting that these higher dividend payers tend to be larger and find it easier to raise external capital.

It’s certainly a counter-intuitive idea for investors to look for larger companies with lower free cashflow, but those companies with residual dividend policies tend to have longer term outlooks than others. In essence these companies don’t actually aim to run with low free cashflow but instead set dividend policy based on expected long-term earnings, rather than adjusting based on the short-term winds of fortune. So perhaps this finding is simply stating that those companies whose managements take a long term view and want to maintain a stable shareholder base are likely to be better aligned with their long-term owners than others.

Note, though, that “alignment” means understanding shareholder psychology and playing to it, attending to the lessons of behavioural finance. This isn’t necessarily the same as maximising shareholder value as promoted by more orthodox economic theories. We’ll revisit this issue, soon.

Dividends Are Not Enough

However, it’s fairly clear that deciding on an investment policy purely on the basis of dividends without regard to the nature of the underlying corporation is a pretty stupid idea and one that’s founded in behavioural fallacies. The behavioural tricks and twitches that make people adopt this kind of approach regardless of the underlying robustness of the institutions involved is simply another facet of the psychological blindness that many investors have with regards to stockmarket investment.

In the end, there’s none so foolish as those that are blinded by their own behavioural failings. Most of us can recognise the psychological problems of stockmarket investing in others yet the majority of people will still fail to acknowledge their own issues. Dividends are simply the tip of a very a large problem. Still, on the positive side, well managed dividend payers are amongst the best bets in the market. Just don’t forget to reinvest the dividends while you can, otherwise you’re spending the majority of your future wealth.


Related Articles: Real Fortune Telling, Buyback Brouhaha, Debt Matters, Don’t Overpay for Growth

Retirees, Procrastinate At Your Peril

Fun or Future Famine

Given a choice between doing something light-hearted and fun which brings immediate gratification or something boring and difficult that won’t pay off for decades – if ever – most of us wouldn’t find it very difficult to make a choice. In fact we’re probably designed to operate this way, since the probability of surviving long enough to enjoy our future wasn’t very great for most of human history.

Now, however, things are different. In the developed world most of us are going to live long past our sell-by dates. Which means our in-built tendency to prevaricate over the tricky, boring and very long-term problem of preparing for retirement is an issue that most of us can’t afford to put off a day longer. If we’re to avoid eking out our dwindling days in destitution we need to stop procrastinating, pronto.

Hyperbolic Discounting

Procrastination is the technical term for the preference of pleasure today over pleasure tomorrow. It’s been the subject of considerable research because the failure of tomorrow’s pensioners to plan for their old-age is a major concern for governments. They’d rather not have to deal at all with old people who don’t pay any taxes and who are a burden on healthcare services, but when they haven’t got any savings they’re worse than a nuisance as they tend to moan a lot and generally vote the wrong way.

One of the odder impacts of procrastination is the effect of time as captured by something called hyperbolic discounting utility. Generally people will take $100 today over $110 tomorrow but would rather have $110 in twenty one days over $100 in twenty. Of course, when the days count down and day 20 becomes today they reverse their preferences. This is profoundly irrational because over such short periods the risk of not being paid is minimal.

Paying Through The Nose

Our desire for short-term gratification and our inability to properly calculate the cost of money allows companies to make heaps of profits out of us. Pretty well anything that enables us to get what we want today without paying for it until tomorrow is enough to get us hooked. So offers of instant credit by stores gets people buying on the never-never like there’s no tomorrow. Only there is, and when it comes we pay through the nose.

Of course, the counter argument is that people should show more self-restraint and that our consumer oriented economy is at fault. The evidence, sadly, is that self-restraint is the exception, not the norm, and people like consuming: it stimulates the limbic centres of the brain and makes them feel happy. Extreme shopaholics have to be treated by drugs targeting these areas, such is the addiction issue.

Hedonism Versus Inertia

Stores aren’t the only beneficiaries of our short-term hedonistic ways. Credit card companies are well known for offering low or zero teaser interest rates to get people to switch, only to rack up the fees later on. The huge impact of the short-term is shown again by research which demonstrates that people will go for the lowest possible initial rate even if offered a better deal with a slightly higher starting rate.

The credit card transfer effect is, in fact, a war between two competing tendencies – short-term pleasure seeking and basic inertia. The rates have to be so good because otherwise we just can’t be bothered to change our ways. Banks habitually take advantage of this by offering zero interest on checking accounts and higher interest savings accounts. No matter how easy it is to transfer funds we generally don’t bother doing so, presumably because we’re out shopping and filling in credit card applications.

The list goes on: preferential insurance rates for new customers, payday loans, mortgage protection policies and extended warranties for instance. The latter two products capitalise on another psychological trait, by the way: the tendency to not worry about small add-on costs when you’ve just made a large purchase. That’s why a salesperson will always sell you a suit first and the accessories afterwards – when compared to the large upfront cost of the expensive suit it’s relatively easy to sell other items afterwards because we anchor on the big number. Suits you, sir.

Retirement Planning Isn’t Pleasant

However, the problem of procrastination goes way beyond the simple issue of instant gratification versus delayed pleasure. Whenever we decide to do something we implicitly decide not to do other things. Even more, we need to decide which tasks to devote time to and which to simply skim over. More difficult and less pleasurable tasks – such as planning how to save money for retirement – are likely to find themselves at the bottom of the list. If they get done at all procrastination will tend to ensure that they’re done inadequately: so retirement planning defaults to what someone who knows a friend who’s consulted an advisor is doing.

Anyway, it’s doubtful if most people can figure out how much they need to retire on. Take Harry Markowitz, the inventor of modern portfolio theory. Did he analyse the co-variances of the various asset classes available to him to figure out an efficient frontier in order to design a portfolio optimised to give him the best return for the lowest risk?

Did he heck.

He did what most people do and split up his contributions equally between the available asset classes. However, there’s a lesson here as well. Better a roughly right decision made quickly than a perfect solution that takes a decade to implement. The time to act is now. Always.

Dumb, Dumber and Poor

As ever in finance financial biases are most damaging to those people with less understanding of the problem area. Procrastination is no different. So reasonably aware and switched on investors are less likely to delay sorting out their finances. As O’Donaghue and Rabin have shown, even relatively low levels of problems with self-control can cause naive investors to avoid the issue completely. It falls in the class of “too hard” so they never get round to dealing with it.

But it gets worse (of course it does, this is the Psy-Fi Blog). Understandably people are more likely to procrastinate over important issues than minor ones. So, for instance, someone may decide to sort out their retirement savings issue but then be unable to complete the task because they’re presented with too many options. Fear of getting things wrong may mean that they end up doing nothing.

The researchers argue that three factors interact to determine whether or not procrastination takes place – self control or lack thereof, domain knowledge or a similar lack thereof and the range of possible options. Even people with good knowledge and exemplary self control may end up dithering if presented with too large a range of options. And, to cap the issue, the more important an issue is, the more procrastination is likely. So investing $100,000 is likely to prove harder than investing $10,000. Although presumably spending it wouldn’t provoke the same level of cognitive dissonance.

Paralysis By Analysis

The odd, but inevitable conclusion, from this research is that when figuring out what to do about the tricky business of retirement investing people may never get around to doing it because it’s too important. It’s hard to know what’s worse – a mass of pleasure seeking, live for the moment hedonists ignoring their retirement problems because of lack of self-control or the responsible and thoughtful folks who are paralysed by analysis.

The answer to this appears to be one that sits uncomfortably with democratic, free market ideals – to use our behavioural biases to coerce people into doing what’s best for themselves. Whether you agree with it or not the evidence is clear: if we don’t help people help themselves then we’re looking at a grim future for millions of dumpster diving pensioners. The alternative may be waking up to find a granny in your garbage.


Related Articles: It’s Not Different This Time, The End of the Age of Retirement, Don’t Lose Money in the Stupid Corner