Money Matters: Mental Traps that Cost People Money Transcript

0:00:00.0 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a Certified Financial Planner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals, and he's joining us now by phone. Good morning, Scott.

0:00:22.6 Scott Oeth: Good morning, CJ.

0:00:24.2 CJ: We were sort of batting some possible topics around. We started thinking maybe we would talk tax, but then you decided that maybe we should look at some... I'm gonna quote you here, "mental traps" that can cost people money or lead to poor decision-making. That sounds perfect.

0:00:45.2 SO: Yes, I think it's important. We are in such a different spot in so many ways now than we were a year ago, but certainly, the market is one of those places. The economy is starting to really gain steam. There's a lot re-opening, trade, but the financial markets are soaring, they're at all time highs, and the things I'm seeing people talk about, the things that are giving me some concern are the other side of the coin than they were a year ago. A year ago, we were talking about fear, we were talking about panic, we were talking about, don't necessarily run for the exits, and now I'm gonna advise caution on the other side.

0:01:30.3 CJ: Okay.

0:01:30.4 SO: So here are some general observations. Some of these are based on research. There's a lot of psychologists studying these effects and how people think about money, but this is not specific advice, folks need to seek their own counsel and do their own research. There's something called the Hot Hand Fallacy. This is a term that psychologists have actually identified when they're studying behavioral finance, how people make decisions around on money, and this came to mind as I was having a conversation the other day, and a friend was talking about how good their spouse was doing in the market, picking great stocks, winners, making huge returns, and they listed off the names of a few of these companies, and I was kinda like, "Yeah, that's not a surprise, Joe. Those are the market leaders." And it kind of begs the age-old question, "Were they really good or were they just lucky?" And the problem is these streaks don't run forever and you can become over-confident.

0:02:27.3 SO: What's going on here is economists in behavioral finance have realized that with the hot hand fallacy, people when they're doing well tend to think they're gonna continue to do well. And there's research that has repeatedly shown that people can be influenced by this, by what they call extrapolation bias. For instance, people gambling in the casino, if they win, they tend to go on and bet more after winning than they do after losing. It's just something to be aware of and to exercise some caution. It's great. I'm happy a lot of people are doing well, these are the rewards for going through the tough times like we had a year ago when the markets had bottomed out.

0:03:11.2 SO: So it's a good thing, but you just need to exercise against over caution and really think, is this skill that's driving these results? Am I really that good? Or is this a rising tide lifting the entire market and maybe jumping on, piling on some really leading stocks or funds that are turning in great returns?

So something to exercise caution with there, and that kind of leads into the second thing and that's this idea of Greater Fool Theory, and I think where we most often see this is more of an unconscious issue, and that would be someone seeing the price of A, B, C or X, Y, Z, whatever it is, some type of financial holding has risen greatly in value and there's this tremendous impulse to get on board. There's the fear that they're missing out, they're missing the returns, missing the ride, and they say, well, they only see it going up and going one direction. People will buy in to whatever this holding is. There's a number of these types of things out there today.

Without really looking at the financials, without looking at it like a financial analyst, or a financial advisor, an economist would, and trying to say, what is the value in this holding? What are the assets? What are the earnings? What type of interest is being paid?

They're more just looking at purely that price and how it's being driven up. And the greater fool theory is that, well, there will always be a greater fool, someone else to come along behind you and pay a higher price and let you sell when you wanna get out.

But the problem is, it's kinda like the old game of musical chairs. It doesn't always work that way. Even good holdings and even broad categories of the market, there's what's called Mean Reversion. If assets have a period of extraordinary high returns, the assets then tend to revert back to their long-term mean, and you don't wanna be stuck when the music stops, being the person holding that asset, that was really over-valued.

Some people are short-term traders and they try and specifically make money off of short-term runs like that. Again, as a general comment, people should get their own expert advice, but that's a very, very tough game to play and to consistently win at.

And for most folks, adopting a long-term strategy, long-term holdings makes a lot of sense, and being cautious about not paying too much for something. Make sure you know what you're buying and what the value is, instead of just looking at the recent returns. You don't wanna be someone else's greater fool!

0:05:49.5 CJ: Indeed.

0:05:50.4 SO: Yeah. I think the last one, CJ is, it's tax time and people are going through it. We’ve got an extension out until May 15th, but a lot of people are looking at their taxes now, and not many people are real excited about paying their taxes or paying more than they need to, and tax planning is really important. We put a lot of time into it. When I'm working with my clients, I try to be very thoughtful about their overall financial situation and how they can manage their portfolio to minimize the tax drag on the returns, but there's an old saying that financial advisors have adopted, I've really found it to be true is that, you should not let the tax tail wag the investment dog. You really want think about how your dollars are invested and what makes sense from an investment standpoint first, and how you're managing those resources and in your retirement plan, and in your savings, and in any other funds that you may have before thinking about the tax purpose.

0:06:47.7 SO: Because what has happened many times throughout the years, there's a long history of ideas will be promoted as a tax-advantaged investments, a tax avoidance plays, and people will put their money into these things, and oftentimes, they are poor performers. The cost of the holding the investment opportunity is more expensive than what the tax cost would be, they tend to underperform, they can be very volatile or they can be really illiquid.

You can look back, there is real estate limited partnerships in the '80s, and then the tax laws changed and those fell apart, there's oil and gas deals that can be extremely volatile or a low probability. A lot of people put money into various types of insurance products, insurance can be critical, very important to protect someone's financial life or for their family, but it might not always be the best investment approach, especially if it's being done just to minimize taxes because that insurance cost and then the illiquidity can really outweigh the tax cost.

The other thing is that people are sitting on happily again, gains in their portfolio. A lot of folks are, and they might be reluctant to say, "Well, I know I should rebalance. I should take some chips off the table.” These stocks has done very well, I should move to other areas and bring my portfolio back to balance." But there's a reluctance to do that because it can generate a tax bill, and what can happen here is this can really lead to a risky overexposure, and on the other side, it leads to missed opportunities by not investing with the things that are going to be good holdings in the future, but are just currently out of favor. The tax plan is important, but it probably should be the co-pilot and the investment decisions should be in that first chair in the decision making.

0:08:44.1 CJ: Oh, it makes very good sense. And as you talked about each one of those, I could see myself doing each one of them.

0:08:48.9 SO: Well, I'm glad we had this talk, CJ.

0:08:53.0 CJ: I am too, Scott. That's awesome. We're talking with Scott Oeth. And we'll be talking finances with Scott again on the first Wednesday of the month on North Shore Morning. Anything you'd like to add, Scott?

0:09:05.0 SO: Well, I've enjoyed the talk and we have a number of these, all these conversations archived on the WTIP site, so check them out there. We've talked about some of these issues before in the past, I upload them on my blog also, scottoeth.com and happy to field any questions there as well.

0:09:23.4 CJ: Thanks very much. We'll talk with you next month.

0:09:26.4 SO: Great, thanks CJ.

0:09:27.4 CJ: Thank you, Scott.