Seven Paradoxes

“THE INVESTOR’S CHIEF problem—even his worst enemy—is likely to be himself.” So wrote Benjamin Graham, the father of modern investment analysis.

With these words, written in 1949, Graham acknowledged the reality that investors are human. Though he had written an 800-page book on techniques to analyze stocks and bonds, Graham understood that investing is as much about human psychology as it is about numerical analysis.

In the decades since Graham’s passing, an entire field has emerged at the intersection of psychology and finance. Known as behavioral finance, its pioneers include Daniel Kahneman, Amos Tversky and Richard Thaler. Together, they and their peers have identified countless human foibles that interfere with our ability to make good financial decisions. These include hindsight bias, recency bias and overconfidence, among others. On my bookshelf, I have at least as many volumes on behavioral finance as I do on pure financial analysis, so I certainly put stock in these ideas.

At the same time, I think we’re being too hard on ourselves when we lay all of these biases at our feet. We shouldn’t conclude that we’re deficient because we’re so susceptible to biases. Rather, the problem is that finance isn’t a scientific field like math or physics. At best, it’s like chaos theory. Yes, there is some underlying logic, but it’s usually so hard to observe and understand that it might as well be random. The world of personal finance is bedeviled by paradoxes, so no individual—no matter how rational—can always make optimal decisions.

As we plan for our financial future, I think it’s helpful to be cognizant of these paradoxes. While there’s nothing we can do to control or change them, there is great value in being aware of them, so we can approach them with the right tools and the right mindset. Here are just seven of the paradoxes that can bedevil financial decision-making:

1. There’s the paradox that all of the greatest fortunes—Carnegie, Rockefeller, Buffett, Gates—have been made by owning just one stock. And yet the best advice for individual investors is to do the opposite: to own broadly diversified index funds.
2. There’s the paradox that the stock market may appear overvalued and yet it could become even more overvalued before it eventually declines. And when it does decline, it may be to a level that is even higher than where it is today.
3. There’s the paradox that we make plans based on our understanding of the rules—and yet Congress can change the rules on us at any time, as it did just a few weeks ago.
4. There’s the paradox that we base our plans on historical averages—average stock market returns, average interest rates, average inflation rates and so on—and yet we only lead one life, so none of us will experience the average.
5. There’s the paradox that we continue to be attracted to the prestige of high-cost colleges, even though a rational analysis that looks at return on investment tells us that lower-cost state schools are usually the better bet.
6. There’s the paradox that early retirement seems so appealing—and has even turned into a movement—and yet the reality of early retirement suggests that we might be better off staying at our desks.
7. There’s the paradox that retirees’ worst fear is outliving their money and yet few choose the financial product that is purpose-built to solve that problem: the single-premium immediate annuity.

How should you respond to these paradoxes? As you plan for your financial future, embrace the concept of “loosely held views.” In other words, make financial plans, but continuously update your views, question your assumptions and rethink your priorities.

Adam M. Grossman’s previous articles include Cut the Bonds, Got You Covered and An Unkind Act. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Rick Connor

4 years ago

Good stuff Adam. To me, one of the best ways to battle some of these is to automate saving and investing. I can also attest that quasi-early retirement is challenging.

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R Quinn

4 years ago

Excellent article. It points out many things we know, but never think about or in some cases we choose to ignore such as the temptation of prestige colleges or keeping a lump sum to worry about because of the fear of annuities. When it comes to finances and health care human nature has given up on logic.

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David Baese

4 years ago

Adam – Thank you for this very insightful and helpful article. I will archive and ponder it.
Dave

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Roboticus Aquarius

4 years ago

I think some of these things are less a paradox than the result of limited information.
1. If you have an edge, you buy one or few stocks. If you don’t, diversify. – Buffett

4. Supposedly the college premium is far less than it was 4 decades ago… but I think much depends on the individual & their eventual career. My wife knows a young lady in her twenties pulling down $250K annually. She’s brilliant, and went to very well known colleges for undergrad and grad, and degreed in an obviously lucrative field. Highest ROI lists are populated with military and ivy league institutions as well as many low cost public and private institutions

7. SPIAs reduce flexibility, and we spend our lives trying to create options, so the reticence doesn’t surprise me. (Still, I’m gung-ho on getting a deferred SP annuity as insurance against a long life.)

Kudos for finishing with such an excellent suggestion:

As you plan for your financial future, embrace the concept of “loosely held views.”

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