Behaviour Gap
This summary is based on the ideas and learnings from "The Behaviour Gap: Simple Ways To Stop Doing Dumb Things With Money", 1st Edition, by Carl Richards in 2012. The description of the book mentions: "Why do we lose money? It is easy to blame the economy or financial markets, but the real trouble lies in the decisions we make by letting emotion get in the way of smart financial decisions. This distance between what we should do and what we actually do is the behaviour gap. The aim is to help avoid the tendency to buy high and sell low; avoid the pitfalls of generic financial advice; invest assets, time, and energy more wisely; quit spending money and time on things that do not matter; identify real financial goals; start meaningful conversations about money; simplify financial life; and stop losing money". Along with uncovering detrimental behaviour, the author highlights that it is never too late to make a fresh financial start.
Summary Disclaimer
It should be emphasized that the summary only includes the content which was found to be relevant. There may have been additional information for many chapters, but it was seen to be unnecessary or incorrect in several cases. In this sense and as a consequence, the information included in the summary may appear different from the information included in the book. Finally, there is every possibility some information was mistakenly missed while reading the book.
Introduction
Everyone protects themselves to a point. Risk is what is left when someone thinks that they have thought of everything. The assumptions about the future are almost always wrong. It is not possible to think of everything, but sensible steps can be taken to protect against inevitable surprises. This uncertainty can be embraced and change is not always a problem. Most of the surprises in life tend to be good news. It is possible to recognize and seize opportunities when they come up if the current plan is not rigid. It is possible to decide what is really wanted, such that decisions align with this goal. The more financial decisions align with what is really wanted, the more successful these financial decisions will be (such as how much insurance to buy, where to invest money, whether to quit a job, or whether to start a new venture). There is no secret to getting rich, but, in the end, financial decisions are not about getting rich - they are about getting what is actually wanted for personal happiness. If there is a secret to getting happy, it is being true to oneself.
We Do Not Beat The Market
Companies like Morningstar and Dalbar try to compare the returns investors yield to the returns investments actually yield. Typically, the studies find that the returns investors have earned over time are much lower than the returns of the average investment. For example, all an investor had to do was put their money in an average stock index fund and let it accumulate, but most investors did not do this - instead, they moved their money in and out of arbitrary funds with miserable timing and costs. The behaviour gap refers to the gap between investor returns and investment returns.
In short, investors as a group tend to be horrendously bad at timing the market. It makes far more sense to ignore what the crowd is doing and base investment decisions on what is needed to reach certain goals. Unfortunately, it feels right to sell when everyone else is scared and buy when everyone else is ecstatic. However, even if it may feel right, it is not rational. The process of financial advice should involve having a real plan, finding investment to populate this plan, admitting it if there are any problems, facing the fact that cash is not a solution to a crisis, developing a checklist of questions to ask before making major financial decisions, taking time with implementation, incorporating new information slowly, and focussing on behaviour (not external behaviours in the market).
When an investment performs well, investors tend to assign the credit to themselves. However, when an investment performs poorly, investors tend to find someone to blame, like the rogue investment banks who wrecked the economy, out-of-control government spending, lies in the media, arbitrary bad weather, and so on. A couple of winning picks can lead the investors to be overconfidence in their skill - if someone does not think this affects them, then they are probably being overconfident. Ironically, the people who are the most overconfident are usually the ones least likely to realize it. Unfortunately, as the level of overconfidence increases, the cost of mistakes usually increases as well, as this overconfidence often leads to being willing to take on more risk.
Perfect Investment
The rate of return of an investment is only one relatively small part of the equation. The pursuit of higher investment returns may make a positive difference in outlook, but there are other things which can be done which have a higher certainty of outcome. For example, consider saving a little more if possible or retiring a little later or pursuing a second career if necessary. Planning finances should be a balancing act rather than a single-minded pursuit of the highest return. Real planning requires thought, frequent course corrections, and effort to keep things in balance - finding this balance is a different process for everyone.
Whenever a fund advertises performance, the SEC requires that it include a disclaimer that the past performance of the fund is not necessarily a predictor of future results. A study by researchers at Arizona State University and Wake Forest School Of Law suggest that this warning is probably not enough. The researchers recommend a stronger statement explicitly stating that it should not be expected for the quoted past performance to continue in the future and studies show that mutual funds which have outperformed their peers in the past generally do not outperform them in the future (as strong past performance is often a matter of chance rather than skill). Despite this warning and pretty conclusive evidence that past performance has very little predictive value, most investors still use performance as the predominant factor in choosing investments. It turns out that fees are the only factor which reliably predicts the performance of a fund. The higher the expense ratio, the worse the performance for shareholders. This is a case where investors actually get what they do not pay for at the end of the day.
People have a tendency to assume that what they do know is more important than what they do not know. This can make sense, as people usually grow up hoping and believing that superheroes and magic are real, root for underdogs even though they know beating the favourite will take a miracle, and buy lottery tickets despite the almost impossible odds. It does not feel crazy to believe that the stars will align and a financial decision will change their lives forever - in fact, it feels good. The problem is that, when they chase after a particular investment, they lose sight of the things which actually matter, like goals and plans. Fantasies are only fun while they last and, sooner or later, everyone must face reality.
Ignore Advice
People tend to give advice which is based on their own fears, experience, expertise, and motivations. Their advice typically has little to do with the reality of life faced by someone else. Furthermore, most of the advice in the media is even worse and typically has little or nothing to do with anything. In addition, predictions, with their accompanying explicit or implied advice about what to do, are the worst. In 2010, The New York Times ran an article which offered advice from an expert who suggested that individual investors should move completely out of the market and hold cash or cash equivalents, like Treasury bills, for years to come. Unfortunately, the article got lots of attention and was among the most shared articles for several days. The decade since 2010 was among the most favourable in history.
It should always be kept in mind that no one knows what the future holds. History does not really help except to show that it is difficult to forecast accurately. If enough people make enough guesses, someone is bound to get at least a few of them right - even a broken clock is right twice a day. So, when someone calls a market turn correctly, it is almost always mostly likely luck. Early in 2011, Robert Shiller predicted that the S&P 500 would only rise from 1,280 on 2011-01-10 to 1,430 over the next decade, which is equivalent to an increase of only 1.3% per year.
Financial Life Planning
Happiness is more about expectations and desire than it is about income. A recent study by Daniel Kahneman and Angus Deaton found that Americans report an increase in happiness as their incomes rise to $75,000 a year. After this, the impact of rising income on happiness levels off. This makes sense, as most people find that it is pretty difficult to be happy when they cannot afford food, shelter, or health care - it helps to add a hobby, social life, and some travel. Once someone has these things, they can afford to turn their attention to deeper needs, such as love and personal growth, which money may not be able to address in a genuine and meaningful way.
All of this means that it is necessary to decide what will lead to happiness and then make financial decisions which support those goals. If someone wants community and shared purpose, they might go work for a non-profit foundation or, if someone wants to retire early, they should try to maximize their salary. It should not be a question of whether something is a good or bad financial decision, as most situations are not actually financial, so the question does not necessarily make sense. Most situations are about life decision, so, before deciding on financial goals, it is necessary to choose life goals.
Money can buy happiness up to a point. Some money is required to be happy, but, once the basics are satisfied, the link between money and happiness quickly fades. In most cases, experiences matter more than objects. At some point, objects stop being new and shiny toys, but this does not necessarily apply to time with friends and family. These experiences may only last a few days or hours, but the memories created will bring greater happiness going forward than an object which gets old and common after some time. Also, happiness tends to appear when it is allowed to without conscious pursuit, as there is no guarantee that happiness will arrive when it is pursued - often, people get caught up in the pursuit and miss the point. Maybe happiness comes easiest when people are so busy working, taking care of kids, shovelling snow, or cleaning the house that they forget to look for it.
Modern society tends to concentrate on the wrong things. Governments track economic trends, but pay little attention to how social programs and institutions affect happiness. Likewise, individuals worry too much about money and not enough about things like fun and love. People should try to imagine if they were financially secure and then the ways in which they would change how they live their life. Similarly, people should try to imagine being told they have only 5 years to 10 years to live and then the ways in which they would change how they live their life. Finally, people should try to imagine being told they have only 24 hours left to live and then the ways in which they would change how they live their life. When thinking about this, they should concentrate on what feelings arise and what they feel disappointed about - self-exploration can be a painful process. It is not always about money, but it is always about life.
Too Much Information
People can only control certain things, so it is usually best if they pay attention to what is happening but do not overrate its significance in their lives. Anxious people tend to buy high due to worrying about missing gains and sell low due to worrying about creating losses. In most cases, monitoring the movements of the stock market will make someone anxious, as every little ripple can potentially flip the boat. Trying to predict the movements of the stock market is even worse.
Researchers have found that what people think about can actually change the structure of their brain, such that patterns of thought become habitual behaviour. The more someone worries about the market, the more they will be inclined to worry about the market. This means that checking performance of investments can become a sort of compulsion. At a certain point, an addiction will form and the primary issue is the emotion which checking can lead to each time. The solution is to spend less time watching and worrying about money and accept that markets cannot be controlled or predicted. This will also help in getting in touch with real goals which can be controlled and, ultimately, a greater sense of personal fulfilment. Often, the less exposure to external information, the higher wellbeing will be experienced.
Many people have a tendency to beat themselves up when they make a financial mistake. However, most people should also spend less time worrying about things they could or should have done differently. Instead, they can use their experiences to help themselves and others avoid similar mistakes without getting involved in feelings of blame or shame. These mistakes can be seen as lessons, where the loss was the cost of admission. Spending too much time worrying about the future can undermine enjoyment of the present. One solution is to distinguish between or separate the time which is spent focusing on planning for the future versus the time which is spent living for today. Planning for the future is very important, but it needs to be done in isolation to avoid overshadowing the reality of today.
Plans Are Worthless
Financial plans are worthless, but the process of financial planning is vital. Planning in its truest sense is a reality-based process which allows for unpredictability and it requires making decisions based on what is actually happening, rather than decisions based on what is hoped or feared. The controversy with planning is that the information needed is not available at the start of the plan. This means that most plans will be based on plausible fiction and likely expectations, but it is hard to account for the fact that a phone call can utterly change life, obligations, and resources. The point is that all of the assumptions in creating a plan are essentially guesses with high uncertainty. For example, how much will be needed to retire is based on future inflation, tax rates, health, life expectancy, and many other aspects. So, the focus should be on the process of planning, rather than obsessing over trying to come up with accurate assumptions.
The process of planning is useful, as it forces decisions to be made about the direction in which someone wants to steer their life. Some basic assumptions can be made, but then it is more important to focus on investigating current motives and circumstances to understand what is actually achievable. The final plan will most certainly be wrong, so it should be planned for to need to make adjustments along the way.
When looking at the best and worst returns of equities for any 1-year period, there would have been a loss of over 40% or a gain of over 60%. This is a very wide range which highlights the uncertainty in short-term planning. However, when looking at the best and worst returns of equities for any 20-year period, there would have been a gain between 3% and 15%. This is a much narrower range and, as the length of the period increases, this range narrows even further. Still, although this range is narrow, the range of possible investment outcomes is still fairly large when compounded over the period, where, for example, the difference between 5% and 7% can be substantial over 20 years.
It should always be kept in mind that the amount of money someone has says very little or nothing about how successful they actually are and it does not necessarily determine the quality of life either. It is simply a single variable of many variables, along with arguably more important ones like skill, talent, generosity, clarity, love, friendship, luck, and many more. Money is ultimately just a tool to reach goals.
Feelings
Feelings can be expensive. Because of feelings, many people feel compelled to hold individual shares in companies in which they irrationally believe. This is especially concerning when it is stock in the company for which someone is employed, as there is an endless list of companies which have gone under and never recovered. Moreover, people often continue to hold investments just because they already own them from previous decisions. This is concerning, as it is often irrational to even hold these investments in the first place, but people are worried that, if they sell it, it might go up in price - no one wants to risk missing out, especially when it is easy to do nothing instead. The problem is that doing nothing will almost always be sub-optimal, especially when the portfolio does not align with actual goals.
A simple test for whether something is actually worthwhile could be to think about what would happen if all of the investments were sold overnight and the portfolio had to be re-constructed the next day. Starting from only cash, it would be necessary to decide on a new portfolio and whether old investments would be re-purchased or if a different portfolio would be constructed. If someone would make changes in this situation, then they should probably make changes anyway regardless of the situation.
One of the more common behavioural mistakes people make is the tendency to get too focussed on a certain value or price for an investment. This primarily occurs when an investor buys an asset for a certain price and refuses to sell the asset unless they get the same or better price for the sale. The problem is that there is no guarantee that they will ever get that same price again and, in many cases, the price may continue to drop further. If the investment was a mistake in the first place, this thinking is illogical, as the appropriate action should be to rectify the mistake as soon as possible. The fact that something cost a certain price in the past should have no bearing on what someone should do with that thing now or in the future. Any decision should be based on what is the most rational given the information currently available.
Whenever making a sudden change in a portfolio, it can be useful to determine if the decision is being made based on feelings or what is actually rational. When dealing with investments there is often this feeling that something should be done and this is emphasized in times of volatility. This is due to a lack of action possibly implying that an opportunity has been missed or mistake is not being rectified. If there is a rational plan in place, leave it and let it work. A popular saying is "do not do something, stand there".
Almost all of the time, someone should never react to new information. There are occasions where someone may need to react to new information and, in most cases, these can be identified by considering, if action is taken on this new information and it turns out to be right, the impact it will have on life and, if action is taken on this new information and it turns out to be wrong, the impact it will have on life. Considering the potential outcomes of being wrong will result in making much better investment decisions.
Responsibility For Behaviour
Bernie Madoff spent most of the past 2 decades running the largest Ponzi scheme in history and defrauded thousands of investors of billions of dollars. Many of those investors were intelligent and sophisticated people - some were top managers at major firms on Wall Street. At the end of the day, he promised the moon and people wanted to believe he could deliver it. Part of the problem with people lies with their almost universal tendency to believe what they want to believe.
It would be nice to believe that a financial advisor has their interests aligned entirely with the interests of their clients. However, in most cases, this is not true. Basically, most financial advisors are trying to make a living from their clients and this leads to conflicts of interest, as the financial advisor would like to extract as much as possible from their client, but their client would like to maintain as much of their money as possible. These conflicts need to be identified and kept in mind whenever paying for advice - when working with a financial advisor, it is important to know how they are compensated. The models of compensation include paying by the hour, paying based on some percentage of assets under management, or paying based on commissions included in products which are sold. No model can eliminate conflicts of interest, although the commission-based model is arguable the worst in this regard as the financial advisor is inclined to recommend products which have the highest commissions rather than the products which would be most appropriate for their client. Additionally, paying based on some percentage of assets under management may lead to the financial advisor trying to maximize the assets under management rather than recommending other decisions which may be more applicable - for example, they may lose money if a client were to withdraw to pay down a mortgage and may not recommend it even if it is the appropriate thing to do. The most important characteristic when choosing a financial advisor is honesty.
It should also be kept in mind that companies are in the business of selling stuff. They have a duty to shareholders to maximize profits and this does not necessarily align with the interests of clients. This is still the case in the financial industry and when dealing with financial institutions. There are exceptions, but it is unwise to pretend that the people on the other side of the desk have a duty to put the interests of their clients in front of those of the firm which employs them.
Investing is not entertainment and people get in trouble when they confuse investing with entertainment. Occasionally, investing becomes a favourite spectator sport with people talking about finding the next popular stock, mutual fund, or alternative investment. Most of the stock market coverage in the media is designed to appeal to fantasies about getting rich quickly. Most people are too eager to accept the story that they can get rich quickly. So, despite somewhat knowing at some level that market timing, stock picking, and day-trading are hazardous to wealth, many people still do these things. So, whenever tempted to play the stock market, maybe go watch a movie instead.
To reach goals, it is necessary to also look at things which are being done which are thought to be helping. In pursuit of financial success, people often get caught up in tasks which actually accomplish very little. The old idea of being penny-wise and pound-foolish applies in most situations. False savings are a common problem for most people, where, for example, they will pursue every possible sale but then decide to finance a car.
Talk About Money
Conversations about money often leave the participants feeling confused, misunderstood, and angry. A reason for this is that money is often used as a stand-in for deeper issues which the participants do not want to discuss. For example, someone may say that they cannot afford something because they are actually anxious about the future or do not think that they actually deserve the things they want - things which go much deeper and are much more interesting although intimidating. It is easier to talk around these issues than to face and acknowledge the underlying feelings. Like religion and politics, money brings up uncomfortable feelings.
When someone says that money is only money, they are usually wrong. There are feelings behind the money which run deep and are often complicated and confusing. It can break up marriages, families, friendships, communities, and even countries. Conversations about money are also complicated by the fact that very few people actually know much about personal finance or investing. It is pretty daunting topic and people have a natural tendency to avoid things which they do not understand. However, money is too important a topic to avoid.
Conversations about money between partners are often complicated by different views on money from each partner. These views are influenced by upbringing, experience, education, and personalities and shape how everyone talks and thinks about money. Inherently, everyone will hold a personal bias, so it is necessary to listen properly to what others are saying in order to understand where they are coming from in conversations. At the same time, it is necessary for someone to find clear language to express how they actually feel about money.
Simple, Not Easy
Most people say they want simplicity, but they will almost always choose complexity. They get trapped between stories of pretending to want simplicity and actually wanting the solution to an important problem to be complex. This tendency to seek comfort in complexity shows up in many aspects of life - people are often disappointed when they discover the solution to something is simple or are not satisfied when a simple solution is provided. In some ways, people avoid simple solutions because these solutions require them to change their behaviour. For example, over $40,000,000,000 is spent each year on weight-loss programs and products, rather than taking the simple and do-it-yourself approach of consuming fewer calories and burning calories with exercise. Most people want a magic bullet which will save them from the grind of changes brought by simplicity, such that they can continue without making changes and still get the benefits.
This attraction to complexity distorts the way people approach their financial goals. The simple options which have the largest impact on financial success require discipline, patience, and hard work. They require the application of basic and boring fundamentals for many years. It is much easier for someone to entertain themselves with the fantasy of finding an investment which will give them a fantastic return than to save a little bit more money each month and put it in a globally diversified portfolio of index funds. But, in the end, the fantasy will almost always fail, while the extra work will almost always pay off.
Like in the story of the tortoise and hare, slow and steady wins the race. It is easy to forget this mantra when most of what is shouted in the financial media is made to sell products or drive traffic to websites for advertising. Unfortunately, slow and steady does not sell products or drive traffic to websites for advertising, as it is extremely boring in the short term (although it is quite exciting in the long term).
Conclusion
The goal is not to make the perfect decision about money every time, but it is to do the best in the moment and then move forward. However, to do this, it is necessary for someone to know where they want to go, such as retirement, travel, or paying for college. Once they have settled on a destination, it is necessary to continuously make decisions which move in that direction. Some course corrections may need to be made along the way, but, if the destination is clearly defined, it becomes much easier to close any behaviour gaps.