Overcome Optimism Bias in your Investments

We know that an investors temperament makes a world of difference with investment results.  Investors can be an irrational bunch.  When the market goes up, they pile into hot stocks hoping to participate in greater fools theory.  That is, they buy a stock only to hope that a greater fool comes along and buy it at an even more irrationally high price.

The problem isn’t only reserved for the upside.  Human tendency has a way to overestimate the upside and underestimate the downside.  There is a term coined for this tendency.  Its called optimism bias.  This mental bias is powerful and is common across ages, races and nationalities.  This behavior suggests that every individual believes they have a greater chance of positive events (lottery winner) occurring and a lesser risk of a negative event (divorce) then others.   Basically this is “bad shit will never happen to me mentality.”

In investing and life, something unforeseen will occur over a lifetime.  Most people don’t like to think about negative events and most won’t plan for them unless someone else helps them along.  Take disability insurance.  Most people only have this if it is offered through their employment.  This survey found that 34% of Americans have disability insurance.   While, this disability awareness website claims that one in four will become disabled before they reach retirement age.

Why so few are planning for these life events?  Probably because its not pleasant thinking and people tend to avoid the thought altogether.  I don’t blame them.  I couldn’t imagine something happening to me or a loved one.

The same situation occurs with investing.  It is often hard to think about what we would do if we saw our portfolio or net worth drop by 20%, 30% or even 40% in a correction.  If you haven’t lived through an event like this, you never know what you will do.  Its depressing, we’ve been there.

How does one cope with optimism bias in investing?  Here is one strategy.

Objective Based Investing

I am reading The Laws of Wealth: Psychology and the secret to investing success.  The author mentions a company that specializes in these types of investment products.  SEI investments actually focuses investment products on specific outcome and goal based objectives.  I am not here to pitch their services but I found their approach interesting and rather intuitive.  You can find the information here.    They focus on goal or objective based investing to help manage optimism bias and hopefully mitigate irrational investor behavior.

They created funds with a focus  on four key objectives:

  • Accumulation
  • Income
  • Inflation Management
  • Capital Stability

I never considered how objective based investing was helping us overcome our optimism bias, but it kind of hit home.  We were actually planning for our goals with an objective in mind.  I even named our portfolios so it is the first thing I see when I log on. Their is some kind of mental reinforcement that occurs immediately.  I understand the goal and objective I am solving for just by name.

This got me to thinking do others name investment accounts?

Here is how we have been doing this in our own portfolios over the years

  • SERIP – “S” is the first letter of my last name.  This is the “S” Early Retirement Investment Portfolio.   This portfolio sits in a single brokerage account and is the portfolio I talk about on this website.  The goal of this portfolio is currently to maximize total return.  Overtime it will shift from 50% dividend growth to all dividend growth companies + bonds + real estate.  The objective of this portfolio is to throw off enough income to fund our lifestyle until standard retirement.  The residual capital will be used to purchase a second home, extended trips around the world, charity or just a contingency plan after we hit age 65. ObjectiveAccumulation/Income
  • Till Death – We have a group of investments made directly in certain companies we feel confident they will be around 50 years from now.  The idea is to never sell and pass them on to our kids.  We will enjoy the income but never take the principal. ObjectiveAccumulation/Income
  • Shorty – We have another brokerage account set up to fund a large short  term purchase.  We haven’t decided what it will be yet, but we know there is a desire.  Options under consideration are pay off our mortgage, purchase a rental property or purchase a fun secondary residence at the beach or on a lake.  The objective of this portfolio is to use the money within 5 years. Objective: Inflation Management
  • SRIP – “S” Retirement Investment Portfolio.  These are our 401k and IRA accounts to fund our lifestyle aged 65+.  Objective: accumulation.
  • Future TPM’s – These are our 529 accounts that will be used within twenty years. Objective: accumulation.
  • McDouble – This is my ESPP account invested in my prior company stock at a 15% discount over time.   Mr. Market has not favored this company yet, but I believe it has a chance to double in the next two years.  I will likely hold for this duration and then sell. Objective: accumulation.
  • Emergency – These are our checking and savings accounts that hold 10 months worth of expenses. Objective: Capital Stability.

These names, while juvenile help me recognize the objective of the portfolio.  Each strategy may change over time.  For instance, the Future TPM’s fund will be transferred from a 100% allocation stocks (accumulation mode) to a 100% allocation to treasury bonds (capital stability.)  Likewise the SERIP will transition from a 100% stock portfolio (accumulation) to a mix of stocks, bonds and real estate (income.)

Each investment have different durations and slightly different strategies to satisfy the goal.  Keeping them compartmentalized and named reinforces the stated goals.

Total Portfolio View

Compartmentalization is helpful for planning specific objectives, but I do not suggest abandoning a total portfolio view of all your investments.  I still advocate that you monitor your entire net worth to make sure you are appropriately diversified across many asset classes for your age.

 

Do you compartmentalize and name your investments?  Care to share?

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