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behavioural finance

There's a story about a financial adviser who has new clients sign a simple one-page form that asks them to check one of two boxes: Box A if you want to "Buy Low and Sell High" and Box B if you want to "Buy High and Sell Low." Everyone asks if he's joking and then reluctantly checks Box A and signs the silly little form.

Invariably, when a market decline occurs down the road, some clients call in asking to sell out of their investments. At this point, the financial adviser faxes over the form and asks them to cross out their answer, check off Box B and then sign and return. Many investors cancel their sell orders after realizing his silly little form was not so silly.

Meir Statman of Santa Clara University is one of the foremost authorities on behavioural finance in the world. His work attempts to gain an understanding of how investment managers and investors themselves make financial decisions and how these decisions affect the financial markets. The jacket of his new book, What Investors Really Want, is littered with praise from a who's who of the investment management world.

"Hindsight is one cognitive error misleading us into believing that we can forecast what we cannot," Prof. Statman says. "Wasn't it clear in 2007 that the stock market would tumble in 2008? Yet what is clear in hindsight is not equally clear in foresight. Is it really clear today whether stock prices will be higher next month or lower? Is it really clear today where the next earthquake will strike?"

He adds, "Confirmation errors compound hindsight errors. We note that radon levels increased before a major earthquake in Italy, confirming our belief that increases in radon levels forecast earthquakes. But we neglect to note the disconfirming evidence of declining radon levels before a major earthquake in California. The same is true for beliefs that particular trading strategies guarantee returns."

I've often said that achieving personal financial success is 90 per cent psychology and 8 per cent math. I've yet to find someone who sees the humour in the missing 2 per cent as a reminder of the insignificance of the math, but I'm sticking to that saying.

It seems to make sense. Investment industry reports often remind us that many retail investors buy high and sell low, when we know we are supposed to buy low and sell high. So why don't we do it?

Industry reports generally take a time period and estimate the rate of return you would have achieved if you had simply left your money in the market. Then they contrast that rate with the actual returns achieved by investors during that time period. The experienced returns are always lower than the potential returns. This is caused by jumping in and out of the market, or switching from fund to fund, at the wrong times.

We tend to get more confident in the market after a few years of strong returns. That means people invest when prices have already run up. We sell after dramatic declines for fear of further losses. That means people sell when prices have already been driven down.

If left to our own devices, I'm convinced investors will continue to make the same mistakes they always make. We spend a lot of time on the 8-per-cent math component, but shoot ourselves in the foot with the 90-per-cent psychology component. Prof. Statman's book, What Investors Really Want, should be required reading not just for investors, but for anyone who deals with money.

Money psychology

Tidbits from Meir Statman's What Investors Really Want

People were offered a higher-paying job in one of two countries. The commute in Country A was shorter by 60 minutes than the commute in Country B. However, one group of people were told that food would cost $5,000 more in Country A than Country B. Another group was told that they would pay $4,000 more in taxes than in Country B. More people chose Country B when presented with a $4,000 tax savings versus a $5,000 food bill savings. This demonstrates that we really hate paying taxes.

When given a gift card, people will tend to spend more than the value of the card. When given a cash gift, people will tend to save some of the cash received. As well, people tend to use gift cards toward luxury items and cash gifts towards more practical, everyday expenditures.

Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is