GUEST BLOG POST: We’re All Human: Even Financial Planners Make Mistakes
September 29, 2011You’ve no doubt heard of shoemaker’s children without shoes. But have you ever heard of a financial planner not heeding their own advice?
We are all human and we all make mistakes. Even when we don’t take the advice we give others. So, I admit it. I have been that same “shoeless” financial planner.
In January 2008, I did something that I would NEVER have advised to my own clients: I bought a second home, more or less on a whim, as my retirement “getaway.” It was a purely emotional decision and my timing stunk. It was the top of the real estate market then.
Like other financial planners, I advise clients to never make decisions based on emotion. People need to take a step back, reflect and really consider the options. They need to look into the future and think about the future costs, future needs and ultimately decide if their decision makes sense for them and their families – now and for years to come.
Hence, my real mistake was not planning for my retirement in terms of the place and community I wanted to be in, what I wanted to door even if I really wanted to fully retire.
Now almost four years later, I have a vacation house that is still charming and historic, but worth a lot less than I paid, and one in which I hardly ever spend any time. It’s too far away from my new workplace, too big and high-maintenance, and the community is just a bit too relaxed for my single, active lifestyle.
In retrospect, my decision was hasty even though it was well-intentioned. I actually was thinking ahead and into the future, but didn’t weigh all of the costs and benefits as I probably should have.
There is absolutely nothing in modern portfolio theory (MPT) that can explain my decision. According to that school of economics, popularized by Nobel-prize winner, William Sharpe, individuals make investment choices seeking to maximize their return while controlling their risk. Further, they take into account all available information when making their decisions. Far from being the rational investor posited by MPT, I was irrational, uninformed and oblivious to the likely returns and risks of my investment.
Fortunately there is a relatively new field of economics that saves me from being called plain foolish, and more gently characterizes me as human. It’s called behavioral economics, and it seeks to explain the mental foibles and tics that prevent most investors from acting in their own self interest. Unlike high speed computers, the size and speed of our anthropoid RAM is limited, leaving us to rely on “heuristics” or faulty mental short cuts when we make decisions.
So back in 2008 when I decided that the 19th Century red farmhouse just had to be mine, it appears that the following heuristics were acting out big time in my otherwise sensible CFP® professional mind:
- Availability bias: This describes the tendency for individuals to use what is now happening to project what will happen in the future. If it’s raining today, the best guess is that it will rain tomorrow. If the value of vacation properties is rising, then my best guess four years ago was that they would continue to rise. Another less flattering term for this bias is “herd instinct.”
- Overconfidence bias: This is in evidence when you ask a roomful of people if they are above-average drivers, and 80 percent say yes, when statistically half of them must be below average. Could there have been just a wee bit of overconfidence at work, when I as the financial advisor decided I didn’t need to do a lot of analysis or planning when I put in my purchase contract?
- Impact bias: This pertains to the tendency for people to overestimate the length or intensity of how they will feel in the future. This is often seen in boat owners, of whom it is said that the two happiest days in their lives are the day they buy the boat, and the day they sell it. Same apparently is true of me as a home owner. I found that the process of purchasing a home exciting, and I assumed that I would always love the house as much as I did on day one. It’s good news to sellers that I tend to forget the inevitable downsides to ownership in the exhilaration of purchase.
My farmhouse has not, however, been a complete disaster. I must say, overconfidently perhaps, that I have redeemed my lapse in judgment by other, better decisions I’ve made. For one thing, I did not go into debt for the home, so the phrase being “underwater” only pertains to the fact that the house is in a 100-year floodplain, and not to negative equity. I also decided to rent the house, which gives me some nice tax deductions for depreciation and maintenance, and keeps me cash-flow positive.
I would tell you I am going to hang on to the house until the real estate market rebounds, but I’m afraid some behaviorist out there might accuse me of the “sunk cost” fallacy. Surely the housing market will bounce back, right? If for no better reason than this rational, experienced, well-trained CFP® professional believes, it has to…