Monday, July 23, 2012

Thinking About Money: Psychology & Investing

One of my favorite topics to study on the financial markets is the psychology of the masses and the psychology of the individual trader/investor. When it comes to money and investing it fascinates me how people can make (irrational) decisions that they would never make in another area of their life.

For example, people often ask me what they should do with X amount of dollars they have received for a tax return, bonus, etc. They will tell me that they can pay down their credit card debt, which they are currently paying 21% per year on, or they could put it into an investment such as a CD or bond fund that yields 3%. Or they ask an even easier question such as should they pay down the credit card or should they pay off their car loan (6%).

The answer to these questions are probably very obvious to almost everyone who is reading this, but it amazes me how often a questions like this comes up.

(The answer briefly to question one would be to pay down the credit debt. Not paying 21% per year is much better than receiving 3%. You get a total positive expectation of 18% by paying off the card. In the second example again you would pay down the credit card debt vs. the car debt receiving a positive expectation of 15%.)

It is certainly not that the people asking these questions are unintelligent. It is just that most people think irrationally about money. Most investors do not think of their portfolio as one large investment (both on the debt and investment side).

Another example is someone that has $300,000 in available cash. They would like to purchase a home and are deciding on whether or not to pay cash. The monthly mortgage rate is currently 3.5% for 30 years. Their financial advisor has a laddered bond portfolio they can invest in with rolling safe short term bonds that would pay them 5% annually. What should they do?

Almost everyone I speak with automatically would prefer to pay cash for the home. I ask them how much of a return on their money they will receive by paying cash? Or how much of a return on their money they will receive on the money they use as a down payment? The answer is nothing. They receive a savings of 3.5% interest.

If they decided to invest $200,000 after putting a $100,000 down payment they would receive a positive expectation of 1.5% (5% bond fund payment - 3.5% they pay on the mortgage) annually. That is an extra $3,000 per year they could use to go on a vacation.

Now, some will argue that the bonds could go down in value or they have a risk of defaulting. This is true, and it needs to be weighed against the decision. An argument against that is that a home could go down in value. Many have found out over the past few years that their $300,000 "investment" into a home is now worth only $225,000.

In a final example, I have given advice to some people recently on how I would recommend structuring their portfolio, or a portion of their portfolio.

Based on current the current market environment, their investment goals, and their complete financial picture, I recommended putting a small percentage of their portfolio into precious metals and natural resources, a small percentage into a fund that shorts the market, and a very large percentage into safe cash. I told them that we are hoping for all assets to sell off because it will increase the value of their cash, usually coinciding with a strengthening of the US dollar. This will allow them to purchase more assets than they could yesterday. In other words their largest investment, cash, would be going up in value.

Then the market sells off (just as we wanted) and their small portion of the fund in precious metals and natural resources fall in value and they get upset. Why? They are not looking at their portfolio as one large investment. The majority of their total asset pool went up in value (cash and short fund) but they only see the red in the other investments.

In the following video Daniel Kahneman, one of my favorite authors, discusses some of these topics on behavioral psychology and investing.

I am not a financial advisor and do not recommend any of the strategies discussed here. They are strictly to provide examples on the psychology that goes behind making investment decisions.

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