Emotions Make Financial Decisions More Complicated

The law of supply and demand is the basis for how people behave with their money.  With most products, if you offer a lower price for a product, the demand will rise.  Some products are more responsive to price movements than others.  People often pass up a “buy one, get one free” offer because they just don’t need more of that item.  That’s an easier decision with items that satisfy definite, but limited, needs, such as food or gas.  Items with an intangible appeal are more vulnerable to price increases.  Perceived image is a perfect example of an intangible benefit that people are often willing to pay more for.   When advertisers appeal to human emotions and desires, the law of supply and demand becomes more complex.   

 If you can convince consumers, through advertising, that your product will bestow them with a certain image, you can get him to spend more for a car that he can wisely afford.  Convince someone that the stock market is going to keep rising and he will make risky bets with his money so he doesn’t miss out.   Isaac Newton, after he lost his shirt in the collapse of the South Sea Bubble, said “I can calculate the motion of heavenly bodies, but not the madness of men.” 

It’s a Complex System

When you combine emotional financial decisions with technological innovation, the world becomes an extremely complex thing to understand, let alone predict.  While human nature doesn’t change quickly, technology certainly does.  

As the complexity increases, changes in one part of the economy produce changes in another.  As new products and services are introduced, old ones become obsolete.  The economic system goes through some disruption but this “creative destruction” allows the economy to evolve in a way that is beneficial for most people.   

This has happened throughout history and at an ever-increasing pace.  But when change happens so quickly, it becomes hard to predict or to adapt to the outcome.  No one predicted, for example, that the cordless phone would lead to the cell phone, then to the smartphone, which would cause teenagers to develop personality disorders from too much “screen time” or cause car accidents from texting while driving. 

Complexity Creates Unknown Risks

The complexity of the financial world became apparent in the crisis of 2008-09.  Financial instruments became so dependent on derivatives and involved many counter-parties.  Securities that appeared to be safe, triple A even, contained risks from parties that were many times removed from the original issuer.  The government stepped in to protect the banking system from collapsing.   Many small banks failed or were taken over by larger banks which, with government support, emerged even stronger.  Banks that were deemed to be “too big to fail” are now much bigger.  

Today, not surprisingly, the world is much more complex than in 2008.  The iPhone was introduced in 2007.  Today people are using it for everything, including banking and trading stocks.   Since 2008, the Fed has not allowed the system to become disrupted.  This has created a moral hazard that encourages people to believe they can take risks without consequences.  And technology allows them to do it faster.  The longer it continues, the more the excessive risks appear to be worth it.  And so risk levels increase even more.  The Fed has allowed it to continue because the system is so burdened with debt that an interest rate increase could be the snowflake that causes the avalanche.  

The result is what economist Paul McCulley calls “stable disequilibrium” – a seemingly stable network of financial relationships that are built on fault lines of instability.  Hyman Minsky was an economist who explained how long periods of stability lead to excessive speculation and ultimately to a collapse.  The so-called “Minsky Moment” comes when, like Wile E. Coyote after he’s gone off a cliff, investors come to see the risks and they all try to sell but realize there are no buyers.   Their fear of missing out on more profit becomes the fear of losing more money.  

When a geological fault line is disrupted, an earthquake can cause a tsunami in some distant place.  Fault lines in the financial system are so complex, that a potential disruption can’t be measured or predicted.   Richard Feynman, a Nobel Prize physicist, once said “Imagine how much harder physics would be if electrons had feelings!”

Have a Risk Appropriate Investment Plan

One key theme in financial planning is to protect yourself from extraordinary risk.  Not from all risk, because risk and reward go together.  Risk is the price you pay for higher returns.  

Like those advertisers who appeal to emotions to sell intangible benefits, Wall Street convinces you to pay more for an investment than you can prudently afford.   But the potential reward must be evaluated in terms of the risk to your financial future.  Risk is not just the probability of a loss.  It’s also about the severity and the consequences of the loss.   The longer the market goes without a correction, the larger the potential loss becomes.

The goal is to achieve a level of wealth that allows you to be in financial control of a comfortable life.  The goal is not to drive a fancier car than your neighbor or to make more than him in the stock market.  Keep your eye on the prize and don’t let the fear of missing out push you into taking too much risk.

Investing is important because it allows for the compounding of returns over time.   But compounding doesn’t work if there are big losses.   A decline of 50% requires a subsequent return of 100% just to break even.   Since 2000 we have had two stock market declines of almost 50%.  They happened very quickly but the subsequent recoveries took 7 years.   If you have to tap into your portfolio before it recovers, the money you take out will never get a chance to recover.   

The risk you have in your portfolio should be appropriate for your age and investment personality.  And it must allow for a margin of safety, considering that in a complex world unpredictable events happen more often than people expect.  

Of course, this means you must have a well-thought out, risk-appropriate financial plan.   Learn more about our approach to financial planning.