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FALL 2016
P E R S P E C T I V E S
BEHAVIORAL FINANCE: OVERCOMING YOUR NATURAL INSTINCTS TO OUTSMART YOUR LIZARD BRAIN
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In this issue:
Our Brains on Jungle versus Market Time
Running with the Herd versus Carving our Own Path
The Best Decisions are Not Made in an Emotional Vacuum
Long-Term Perspective is Vital
Context Matters
Understanding Risk and What You Can’t Control
Focus on What You Can Control
Diversification Matters
Remember There’s More to Life than Money
Contributors:
Carol Schleif, CFA Deputy Chief Investment O er, Asset Management
Pat Armstrong
Senior Director, Family Dynamics and Education
We are not, as a species, naturally suited to make wise
investment decisions. In fact, much of our ancient
coding is hard wired to lead us toward instinctively poor
choices, particularly in the heat of an unanticipated event.
Understanding these innate tendencies is the critical first
step in being able to deploy thought and action patterns
that counteract the most destructive of our genetically
ingrained responses.
Traditional economic theory teaches that humans make
financial decisions in a calm, collected, rational way after
carefully evaluating all viable alternatives (what economists
call “homo economicus”). Social scientists, psychologists,
and an increasingly large body of well-documented brain
science studies point to a much di erent reality, especially
as it relates to day-to-day market action. Dating back
at least to the frenzy over tulip bulbs in the 1600s, asset
markets have been subjected to panics, hysterias, euphoric
blo nd deeper-than-dictated-by-mere-fundamentals
drawdowns with a regularity that traditional theory cannot
explain. In most corners of asset pricing, greed and fear
mark the extremes with much more reliability than rational
thought process.
Think you’re immune? How did you respond amidst the
recent Brexit-induced market frenzy? Did your heartbeat
pick up as you saw the downdrafts in global markets in the
initial post-vote days? Did your breath get shallow even as
your nerves prompted action? Welcome to the deep-seated
survival instinct emanating from the most primitive of brain
segments, what some scientists a ectionately refer to as
your “lizard brain.”
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Our Brains on Jungle versus Market Time It’s reported that a single edition of a daily national
newspaper contains more information than someone living
in the 1700s would have been exposed to in a lifetime.
Similarly, a recent Forbes 1 article notes that more data has
been created in the past two years than was created in the
entire previous history of the human race.
The “problem” with this pace of innovation is that our
human brains simply can’t keep up; it takes a long time to
change how they are organized. In evolutionary terms, “a
long time” means centuries—if not millennia—not a mere
decade or two. Though our technological environment has
reached a tipping point of inventive-speed, our brains are
still better organized to respond to threats in our native
habitat (i.e., the steppes or jungles).
For example, one of the key factors that ensured the survival
of our species is a finely tuned “fight or flight” response.
Though today we may not deal with life and death issues
every day, our brains still function as if we do. Scientists
have documented that when we are faced with common
stressors in daily life—tr c, long lines, arguments, 500-
point Dow declines, and April 15—our bodies respond as
The Cycle of Investor Emotions
they have for millions of years: our heart rates increase, we
sweat, our pupils dilate, and “stress hormones” like cortisol
and adrenaline flood our systems. As the bulk of our brain
activity is diverted into some of the deepest and oldest
parts of the cranium, we become fixated on the issue at
hand, often a facto tunnel vision.
In market terms, despite all the sophisticated algorithms,
expanded information access, and tra cies that
have sprung up in recent decades, one core denominator
undergirds it all: human decision making, instruction, and
control. Even if those humans are skilled money managers
and investment committees, numerous studies have shown
they can be prone to lizard-brain-inspired responses under
duress, unless they are consciously aware of and on the
lookout for such potentially problematic behavior.
We are not obligated to be our own worst enemy, however.
Neuroscientists are learning that contrary to popular myth,
losing brain function as we age is not inevitable. We can
actually retrain and strengthen important neural pathways
(i.e., the way we think and process daily events) throughout
life by learning new skills or teaching ourselves to approach
problems from a di erent “angle.” The first step is to admit
that we are all compelled to “misbehave” when it comes to
our own financial well-being and then commit to taking a
di erent course of action.
The Market’s Intrinsic Value
Optimism
Excitement
Thrill
Exuberance
Anxiety
Denial
Fear
Desperation
Panic
Capitulation
Despondency Depression
Hope
Relief
Optimism
Worry Worry
• Risk tolerance increases
• Time horizon expands • Risk tolerance evaporates
• Time horizon compresses
“I’m never getting back in” Point of maximum financial opportunity
“I’m missing out” Point of maximum financial risk
Source: Abbot Downing (then Lowry Hill), January 2010.
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To help in that process, this newsletter highlights the
challenges and lays out core strategies for counteracting
these nearly irresistible urges to sabotage our own financial
well-being.
Running with the Herd versus Carving our Own Path Neuroscientists have discovered that the part of our brain
that registers reaction to being picked last for the team or
excluded from the hottest party in town is the same area
that registers physical pain. We feel intense social and
physical “disconnect” if we are not part of the crowd—
especially if the crowd is spinning an engaging story (think
internet or housing booms) fanned by high-profile media
coverage. In prior days, our very survival depended on our
ability to run as a pack. In the modern investment arena,
however, our “survival” can depend on our ability to think
and act independently. The old adage that the market
vacillates between greed and euphoria is true.
Getting caught up in herd euphoria or depression is essentially allowing “mob rule” to overrun your investment plan.
A key way to short circuit this response is to have a clear
understanding of what you want and need your funds to
accomplish for you, your family, and your community—both
now and perhaps many generations into the future.
A little time spent up front thinking about the big picture—
viewing the scene from 10,000 feet and 10, 25, and 100
years in the future rather than a view from 10 inches away
right now—can create an important touchstone for guiding
you toward long-term success. Think big picture and long
term about what you want your financial legacy to look like.
When friends and family give your eulogy, what messages
do you hope to leave behind?
It can’t be said often enough: don’t just think through your
goals, write them down and refer to them often. When
headlines are especially busy promoting greed or fear, it
is extremely helpful to be able to pull out your long-term
goals, remind yourself of what you are trying to accomplish,
and take action—or not—consistent with these goals.
The Best Decisions are Not Made in an Emotional Vacuum Traditional financial theory implies that investment decisions
are made in an emotional vacuum, typically after calm
and rational assessment of the risk/return parameters of
all possible choices. The real world, however, can be quite
di erent. When asked to ponder their earliest money
memories, most individuals identify a core emotional
component to those early experiences—in much the same
way that particular smells evoke fond childhood memories.
For those who have spent a lifetime of sacrifice and
hard work building a pool of investable assets, emotions
are a vital consideration in planning for investment and
stewardship of funds. Scientific research suggests it is nearly
impossible for us to make wise choices about risk without
engaging our emotions.
Even if rooted in sound financial, investment, or tax theory, decisions that do not allow us to sleep at night are rarely worth the emotional toll they extract.
Long-Term Perspective is Vital Neuroscientists have shown that when faced with a choice
of “now” versus “later,” most of us choose now. In one
classic study, respondents were asked if they would prefer
$10 today or $11 tomorrow. The bulk chose “today.” Oddly
enough, though, when asked if they would take $10 in 365
days or $11 in 366, the bulk of respondents chose to wait
the extra day.2 We suspect that part of the reason for this
is that “today” and “tomorrow” are both palpable, near-
term time periods. But when looking out a year or more,
one day seems as remote as another. An ability to move
beyond this “future fuzziness” syndrome, however, is vital to
grasping important long-term investment concepts such as
compounding (which Einstein, incidentally, labeled the most
important formula of all).
At Abbot Downing, we help clients keep their long-term
perspective in view by:
• Encouraging a holistic view of both sides of a family’s
balance sheet
• Helping clients see the big picture via a variety of planning
tools such as Abbot Downing Clarity
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• Ensuring each portfolio has an appropriate investment
policy statement developed in conjunction with clients
and trustees to reflect unique cash flow needs and other
constraint parameters.
Context Matters When selecting asset allocation targets or individual
investments, the primary consideration should theoretically
be current valuation relative to prospects. In essence, the
process necessitates evaluating the manager, company,
or sector for long-term merits just as a banker, creditor,
or owner would. Despite the logic of taking a measured
approach, however, our decisions are all too easily
influenced by what we have most recently read or heard. Did
you realize, for example, that you are more likely to be hit by
falling airplane parts than bitten by a shark? Probably not,
because the former rarely elicits national media coverage,
while the latter does. Breathless media accounts can easily
influence a person’s emotions, causing market participants
to succumb to “group think” rather than acting according to
sound valuation methodology.
Two core concepts to keep in mind:
1. Investing is a tough, time-consuming activity—not the
“mere” purchase of a lottery ticket.
2. Media stories are created to generate audience interest
to please advertisers—not to reassure us about the
soundness of our investments. Becoming too negative
on the broad market or on certain classes of investments
when all of the headlines are proclaiming doom can
prevent one from initiating or continuing to make wise
investment choices. When headlines are particularly
vociferous, refer to your written plan and long-term goals
as the reference point for your decision.
As you visualize what you want out of your financial plan or
portfolio, we recommend that you also spend time thinking
about what the consequences are if something goes wrong.
This line of thinking is exceedingly tough for most people,
since it carries the implication that our thought process or
analysis may have been flawed at the outset. But markets,
economies, and politics are notoriously unpredictable and it
pays to consider a variety of potential outcomes.
Thinking probabilistically (i.e., there’s a 50% chance that X
will happen and a 30% chance that Y will happen) is not
common in our “all situations are clear-cut/black-and-white”
society, but it can be extremely helpful in defining the
boundaries within which your assets should be managed.
The key outcome of this sort of thinking is apportioning
assets across a variety of categories to hedge your
portfolio against specific risks. For example, you might own
international assets as a potential o et to a depreciating
dollar and/or in recognition of the increase in prominence
of non-U.S. markets, or invest in Treasury Inflation Protected
Securities (TIPS) to hedge against inflation. Think broadly
and open mindedly about a range of potential outcomes. As
Robert J. Shiller states in his book Irrational Exuberance,
“If one tries too hard to be precise, one runs the risk of
being so narrow as to be irrelevant.”
Understanding Risk and What You Can’t Control Risk, like beauty, means di erent things to di erent people.
Further complicating the issue, risk comes in many di erent
forms. There is broad market risk, for example, to investing
in stocks as a category since they have the potential to
fluctuate in price markedly on a day-to-day basis. This
risk can be compounded if your equity investment is
concentrated in a single security, such as the company you
work for or own. Even if you think you know the company
well, you do not have control over the public market’s
collective perception of that company’s worth. As an
example, if your liquid assets support 100% of your income
needs, but are invested 100% in a narrow, volatile asset class
that reprices daily, your perception of risk might be di erent
than if you did not need to withdraw your living wage from
the account.
Realize that risk can shift over time with market, geopolitical,
and economic changes. For example, is buying a 10-year
sovereign bond with a negative yield a “low risk” investment
today, even though developed market government fixed
income is traditionally labeled a “conservative” investment?
Then too, stocks in general in the spring of 2009 seemed
to be pricing at outcomes even more dire than experienced
during the Great Depression. Your own financial situation
inevitably changes too, as children age, businesses are taken
public or sold, and health conditions emerge.
Market variability is often the only risk that most people
consider. Over the long haul, however, there are much
larger risks such as loss of purchasing power (the fact
that $1 today buys $0.97 worth of last year’s goods). An
expensively managed portfolio—one high in fees, turnover,
or taxes—can also represent a pertinent risk and a drain
on your ending net worth. Inelegant tax or legal advice,
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Cognitive Biases in Wealth Planning and Communication
Our cognitive biases a ect not only investment decisions, but our “lizard brain” can also influence decisions regarding wealth planning, including how we communicate with and prepare family stakeholders. Cognitive behavioral psychology teaches us that our feelings and actions are expressions of certain “cognitions” or “automatic thoughts” that influence us without our even noticing.
Actions & Emotions
Self Statements
Core Beliefs
An example that illustrates this model is to delay planning, or communicating your
plan to those who need to know.
Action: Delay or inaction is one of the biggest threats to achieving your
desired outcomes for your beneficiaries.
Self Statements: “I have time to plan. I’m not quite ready to finalize
things. I don’t want to lock things in before I feel certain about what
to do, or before my children are ready.”
Core Belief: “If I communicate my intentions too soon my
children won’t be motivated in their lives.”
Humans have a tendency to avoid decision making
in areas that they have little familiarity or expertise,
especially when there are underlying beliefs or concerns
about the potential outcome of their actions. Take time
to recognize and explore your own beliefs and thoughts
on planning and compare them to known best practices.
Researchers have documented lack of communication
and failure to prepare heirs as the top two reasons why
only about one-third of families with significant wealth
are successful in transferring wealth beyond the second
generation.
Other threats to realizing your goals through planning and
communication include:
• Running with the Herd. It is human nature to follow
what you are familiar with—such as past trust planning
or incentive planning—even though other arrangements
may be more e ective. Customize your planning to
reflect your own values (core beliefs) and be flexible
to deal with future unforeseen circumstances. Because
the tax landscape has changed dramatically over the
last several years, planning in the same manner as
others, including your parents, may actually undermine
your own personal wealth transfer goals. Begin with
values and seek objective advice regarding how to best
achieve your goals.
• Keeping the Status Quo/Failing to Revisit and Update Planning. The fact that you have planned in some
manner is better than the alternative, but keeping
the status quo may actually undermine your personal
objectives. Revisit your financial plan periodically to
make sure that it still aligns with your personal goals
and is the mos cient way to transfer wealth.
Recognizing your personal biases to gravitate toward
the “easiest” alternative is the first step to making sound
personal planning decisions. Take control of your own
planning by recognizing your personal biases—beliefs
and thoughts—and identify those goals most important
to you. Share those goals with your advisors who can
facilitate the planning process. While planning that
others have done may have met with their objectives,
those arrangements may not be the mos n
today’s legislative, tax, and economic environment.
Take ownership of your own situation, identify and
communicate your goals, take action, and periodically
revisit your planning to make sure it still aligns with your
personal objectives.
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especially as it relates to your estate or philanthropic
intentions, can instigate problems (and perhaps ill will)
that last for years. Outline the risks most pertinent to
you and prioritize them in terms of their impact on your
comfort level. Some people, for example, don’t care if their
portfolio’s bottom line gyrates as long as their income needs
are comfortably met. Others can’t sleep at night with any
debt outstanding. Risk is an extremely individual topic, and
a successful and comfortable financial plan won’t work
without taking individual preferences into consideration.
Focus on What You Can Control In ancient days, our survival depended on being able to
recognize patterns and respond appropriately (e.g., learning
to recognize and avoid plants known to be poisonous or
animals known to be predators). Our brains seek patterns
and order—even in places where none can exist. This can
be especially detrimental in the investment arena, since
markets themselves are inherently random. The popular
media is rife with articles predicting the market and the
economy’s next move, as if an accurate prognostication
would yield an investable event. Falling into the fantasy
that we can accurately predict market movements can lead
to attempting to “time” entry into or out of specific asset
classes, which more often leads to missing important moves.
A more fruitful endeavor is to focus on aspects of our
financial situation which can be controlled at least in part:
• Minimizing costs and ensuring they are budgeted toward
areas with the biggest potential payo
• Controlling taxes and turnover
• Ensuring that asset allocation matches near- and long-
term financial goals
• Regularly rebalancing back toward target core
allocations—especially during/after market meltdowns
or melt-ups
• Ensuring adequate cash flow/reserves/credit lines for
near- and intermediate-term needs
• Ensuring appropriate leverage is used
• Ensuring estate and tax plans are current
• Evaluating and securing adequate insurance coverage
• Attending to the financial wherewithal of future
generations and their preparedness to assume the mantle
of family wealth stewardship
• Ensuring family business succession plans are developed
Spend your time getting and keeping a handle on these
factors, and you won’t have time to fret about headlines or
market predictions of gloom or greed.
Diversification Matters Whether or not we admit it, we all want investments with
big growth, big yield, zero downside, and the ability to
sustain hefty withdrawals—all while outperforming whatever
major index is the measure of the day. While it seems
obviously silly when these goals are set out in print, many
of us do look for a single investment to do it all. Just as we
need more than a single club to complete a round of golf,
we cannot rightfully expect one investment to accomplish
all of the goals of a financial plan. Some investments are for
growth, some are for income, and some are for protection.
Appropriately mixing them for various life stages is as much
art as it is science.
On top of all the other things that we want our investments
to do, we also want them to give us bragging rights. Keep
in mind that for every “I made 20% last year in XYZ Widget”
story you hear at a cocktail party, there are likely to be just
as many tales of gruesome blowups or investments gone
seriously awry. It’s human nature to want to pass along only
the stories that put your investment prowess in a favorable
light. When was the last time that you heard someone say,
“I made this incredibly stupid investment last year and lost
my shirt?”
The unfortunate thing about being exposed to the “I made
a killing” stories is that they can lead you to think that your
investment choices are inferior or that you are not as smart
or well-positioned as your friends, neighbors, or coworkers.
Further, this type of information prompts our brains to want
to take some sort of action—and action taken in this context
is more likely to be an emotionally-based reaction, rather
than a thoughtful plan which considers our unique needs.
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any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or hav inconsistent with, and reach different conclusions from, this report.
Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal and tax advisors to determine h
Remember There’s More to Life than Money It’s been said that great fortunes are typically not made in
the markets. Rather, significant personal and family wealth is
more often accumulated over time by success reaped from
building or running a business or by success in a craft or
skill. This is a subtle but vitally important statement. Many
approach the markets—especially the equity markets—as if
one “lucky” purchase will put them on the road to fame and
fortune. The key is developing a mindset and an investment
program to retain the capital invested, balance a variety of
risks pertinent to your individual situation, and keep your
purchasing power ahead of inflation over a long period of
time.
Given both our innate wiring and society’s deification of
capitalism, it is very easy to get caught up in the “money rat
race” and forget that there is so much more to life. While
a well-padded investment account does make paying the
bills easier, money can also bring a host of concerns and a
variety of complex planning and transfer issues—especially
when families are involved. Because money and emotion are
inextricably entwined, it is not surprising that money can
be the cause of heartache, ill will, and family discord. One
of our favorite cartoons shows a portly gentleman at the
gates of heaven with bags full of money tucked under each
arm. St. Peter is at the gate, keys in hand, informing the man:
“And I happen to know they won’t let you take them with
you down there, either.”
The bottom line is that of all the living species, we are the
only one with the ability to place a pause between the
“stimulus and response” sequence. That pause, no matter
how brief, allows us to make choices about how to shape
our response. With a little forethought and planning, our
responses to investment stimuli can be more reasoned and
more like the “homo economicus” that the economists have
been telling us for years we already are.
To learn more about additional Abbot Downing perspectives, please contact your relationship manager or visit our website. www.abbotdowning.com.
1 http://www.forbes.com/sites/bernardmarr/2015/09/30/big-data-20-mind-boggling-facts-everyone-must-read/#4f12a55d6c1d 2Michael Mauboussin, How Do You Compare?, Legg Mason Capital Management, August 9, 2006
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Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Past performance does not indicate future results. The value or income associated with a security or an investment may fluctuate. There is always the potential for loss as well as gain.
The information and opinions in this report were prepared by Abbot Downing and other sources within Wells Fargo Bank, N.A. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Abbot Downing’s opinion as of the date of this report and are for general information purposes only. Abbot Downing does not undertake to advise you of
e opinions that are
ow this information may apply to your own situation. Whether any planned tax result is realized by you depend on the specific facts of your own situation at the time your taxes are prepared.
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