November 5, 2015

Investing Should Be Painful!

Alan S. Roth write in the Nov. 2 issue of Financial Planning 
"In the real world, risk correlates with reward.... Our minds, though, are often disconnected from reality, and we view risk and reward as disconnects."
"People base their judgments of an activity or a technology not only on what they think about it, but also on how they feel about it."
If their feelings toward an activity are favorable, they are moved toward judging the risks as low and the benefits as high; if their feelings toward it are unfavorable, they tend to judge the opposite — high risk, low benefit. Of course, the pattern isn’t logical, but it’s how humans think."
"In his 2011 book, Thinking, Fast and Slow, Nobel Economics Prize winner Daniel Kahneman discussed our two ways of thinking:
System 1: Rapidly, automaticly, frequently, emotionally, stereotypically, subconsciously.
System 2: Slowly, effortfully, infrequently, logically, calculatingly, consciously.
Essentially, system one is rooted in how we feel, while system two is, supposedly, rooted in logic. Two critical points, however, are that both systems reflect how we think, and that we typically don’t know which system we are thinking with. We assume we are always using logic when making decisions."
"System 1 feels more pleasure and pain. It views the stock market as high reward and low risk at the height of bubbles, and high risk and low reward at the bottom.
System 2 always considers stock investing to be risky, but leads to the conclusion that stocks are a better buy after a half-off sale than after the price has doubled. Our thoughts also assess the high probability that capitalism will survive. When stock prices reach an all-time high, System 2 knows there is a low probability that stocks will rise indefinitely without the arrival of a bear market."
"Research indicates that System 1 typically prevails in investing. Most data show investor returns typically lag fund returns due to poor market timing. Fund flow data reveal we buy more stock funds near the top price and sell more near the bottom."
"Behavioral finance readily explains how we can think we are being logical while doing illogical things...."

Read Roth's full discussion at:

1 comment:

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