Now that Richard Thaler was awarded this year’s Nobel prize for economics last month, behavioral economics is all the rage again. Daniel Kahneman won the same Nobel prize back in 2002 for his work behavioral economics work with his late partner Amos Tversky.
These Nobel prize laureates provide insights into understanding human decision-making flaws that occur when making choices. Judgement flaws abound when individual company 401(k) retirement plan participants make investment management decisions.
One of the main problems is woefully incomplete information on default company 401(k) retirement plan mutual fund options. If that state of affairs were not bad enough, individual investors compete with full time investment management professionals armed with some of the most sophisticated software and hardware systems on the planet.
A bias towards continued optimism leads individual investors to have an unrealistic positive view of their past investment management decisions. This state of mind is called cognitive dissonance and leads to overconfidence and overly optimistic decisions.
Since the bottom of the current stock market cycle in March 2009, the U.S. stock markets are now in the second-oldest advance on record without at least a 20% drop in the S&P 500. Now is one of the worst times in history for overconfidence.
On the other side of individual investor behavior is pessimism. Many individual investors were much too scared to remain invested during the last great stock market decline. They were also too afraid to investment their 401(k) monies shortly after March 2009.
I read a blog post last week about one of the most widely followed Warren Buffett stock market valuation indicators. Not surprisingly, it currently resides close to an all-time high.
A bias towards pessimism now can cost individual investors a great deal of money. The U.S. stock markets will eventually fall, but there is no telling how much higher they will climb until that fall occurs.
Guarding against nature human emotions when making investment management decisions is extremely difficult even in the best of conditions. With interest rates and all-time lows and stock markets at all-time highs, it is almost impossible.
Take the time now to think about your current state of mind. Granted, your most recent company 401(k) retirement plan account statement was most likely a working career high water mark. But how will you react in the early stages of the next great stock market decline?
Are you over confident or scared to lose money? It has to be one of those two choices. Each one has its perils. Take the steps necessary to know your most likely behaviors going when the stock markets head the other direction.
Ric Lager
Lager & Company, Inc.
