Friday, February 17, 2012

The Behavior Gap by Carl Richards

I used to stop in at The Behavior Gap blog every so often, and enjoy his cocktail napkin graphs or Venn diagrams illustrating some tidbit of financial wisdom, so I was excited to see that author Carl Richards had written a book, which turns out for the most part to be a compilation of many of the subjects he wrote about on his blog. Richards is a certified financial planner and runs a capital management company in Utah, as well as writing and speaking about money, so he definitely knows his subject, albeit with a twist most financial planners don't have.

The title of the book refers to the difference between the overall return on investments in the stock market and the actual return that the majority of investors get. When the market as a whole goes up, for example 10%, individual investors on average are only getting 6%, and Richards calls the difference, which is caused by irrational or emotional behavior on the part of investors, the Behavior Gap. The book attempts to help us to understand those incorrect behaviors and to quit losing money over them.

Of course, the most common mistake that people make, which I know I personally saw happening during the economic meltdown of 2008, is to buy high and sell low. When all the word on the street is exciting, and prices are going up up up! everyone wants to jump on the bandwagon and buy more stocks - at precisely the time when they should be wary, and should hold or sell, instead. Then, when the market begins its inevitable correction, people tend to be fearful and to sell everything they bought at high prices, locking in losses. When the market is down is the best time to buy, instead. However, it takes a cast iron will and a strong stomach to buck the trend and not follow the herd in these situations.

Another problem is overconfidence. In a bull market especially, investors are prone to thinking that their investment decisions are bulletproof, and will often make decisions about where to invest their money without enough analysis. Richards suggest three questions to ask yourself and to go over the answers with someone you trust before you make an investment decision, which he calls the OC (Overconfidence Conversation):
1. If I make this change, and I am right, what impact will it have on my life?
2. What impact will it have if I am wrong?
3. Have I been wrong before?
Question 3 seems a gimme, but...

I liked what he had to say about the Greater Fool of stock market lore. The most recent example was in the run up to the housing crisis recently, when it seemed everyone was speculating on the rapidly rising price of homes, either using their paper home equity as an ATM by taking out more and more loans, or buying up properties and hoping to sell them after a short period of time for a profit. I was watching all of this happening, as well as the mass migration of previously sane engineers, salesmen and others into the professions of real estate broker, mortgage broker and loan officer, and wondering how long it could go on; how people were affording homes that had skyrocketed in price past all sane loan and budget guidelines. It seems that, when you're doing something dumb, whether it's buying high priced real estate or beanie babies, the only way out is to hope someone else is dumber, and hope they'll come along and take your investment off your hands before the bubble bursts.

It's often difficult to ignore the noise, to hold a steady course with your financial plan (which Richards suggests creating with the help of a professional and then following no matter what Jim Cramer says), while the media is screaming about the end of the world or about old rules no longer applying. Richards says that people are often surprised, in conversations with him at social events, given his profession, at his lack of interest in what the stock market as a whole, or individual investments, are doing. If pressed, he tells them that he helps "people make smart decisions about money so they can build and protect their wealth over time" and that "the ability to build and protect wealth is often inversely related to knowing what's going on in the market." Very refreshing.

This book is a quick, accessible and interesting read. There are lots of his sketches, helping to make what seems complicated very simple, scattered throughout the book. Even if you know nothing about the stock market or about investing, it will all make perfect sense.

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