FREE NEWSLETTER
IT’S INDEPENDENCE Day. But how truly independent are we, both financially and in our thinking? The two, I believe, are inextricably entwined.
Whether it’s the TV shows we watch, the political views we hold or the investments we buy, we often take our cues from family, friends and colleagues. They, in turn, may be influenced by advertising and the media. But however ideas get spread, the result is that most of us aren’t the fiercely independent thinkers we imagine. Instead, all too often, we’re swayed by the mob.
This isn’t always so terrible. As I’ve noted before, there can be great wisdom to crowds. Investors typically do a fine collective job of valuing corporations, as well as anticipating economic growth and inflation. Similarly, consumers collectively are pretty good at figuring out which movies are worth watching, which electronic goods are worth buying and which restaurants are worth visiting. If we want to lose ourselves in an entertaining novel, we should pick a popular one—and we likely won’t be disappointed.
But what’s typically true isn’t always true. Want to grow wealthy? We need to know when to resist the influence of the mob.
Investing sensibly. What are the major investment blunders? We could pay too much in investment costs, make big undiversified investment bets or make radical portfolio changes at just the wrong time. We often make such undiversified bets and radical portfolio shifts because we’re overly influenced by the investment crowd—and these missteps often have the added misfortune of triggering hefty investment costs, including big tax bills.
Think about the panic selling during this year’s market decline. Or ponder the 2017 bitcoin bubble, the 2008-09 stock market collapse, the mid-2000s housing craziness, the late 1990s tech stock mania or the late 1980s Japanese stock market bubble.
What leads people to feed on each other’s exuberance or despair, thus pushing market prices to such extremes? We don’t know for sure. But economists and psychologists have identified various mental mistakes that can cause the investing crowd to become convinced they know what the financial future holds, prompting them to buy or sell en masse.
Four concepts strike me as especially helpful. First, whether investments are rising or falling, there’s usually a good reason—but folks may get overly enthused or scared if the price move is accompanied by a compelling narrative. Look no further than the coronavirus crash, and the competing stories about the potential economic damage.
Second, there’s extrapolation. We often buy rising investments for the simple reason that we assume they’ll keep on rising. Ditto for when we sell falling investments. Closely related to this is recency bias: We ignore longer-run returns and instead come to believe that an investment’s current strong or weak performance is representative of how it typically performs.
As the early buyers or sellers drive prices higher or lower, others notice and they, too, join in. This brings us to a third concept: herding. As we watch prices rise or fall, we assume others must know something we don’t—and we rush to imitate them. If extrapolation leads us to buy investments simply because prices are rising, herding can prompt us to purchase simply because others are doing the same.
All this buying can give prices a further nudge upward. That brings us to a fourth factor, one typically associated with rising markets: overconfidence. As investors make money, they attribute those gains to their own brilliance, often leading them to make even bigger bets. Related to this is the house money effect: Like the casino gamblers who get lucky early in the evening, investors may feel like they’re ahead of the game financially, causing them to take yet larger risks. Where does all this end? Usually in tears.
Spending wisely. Failing to invest sensibly is unfortunate, but at least it means these folks had money to invest in the first place. Arguably, the bigger problem is those who never invest—because they can’t control their spending and hence they have little or no savings.
Why do so many folks save so little? It could be true economic misfortune. It could be the common mistake of overvaluing today and giving scant thought to the needs of our future self. It could be the mistaken belief—fueled by advertising—that happiness lies just one or two purchases away.
But once again, we shouldn’t overlook the influence of the crowd. There’s no doubt an element of herding, as we imitate the spending of others. But even more important, I suspect, is signaling. Rather than loudly announcing our values or showing our financial statements to our neighbors—neither of which I’d recommend—we instead signal our values and our financial success with how we spend our money. That signal could be “I’m frugal” and the sign could be our Subaru with 200,000 miles on it.
But folks typically go the other way, signaling their success with the new car, the big house and the expensive vacation. The irony: While others may indeed see these as signs of financial success, such expenditures leave the folks involved significantly poorer—and often we later discover that they aren’t nearly as prosperous as we imagined.
The upshot: This Independence Day, let’s commit to true financial independence, where we resist the fleeting comfort of the crowd, and instead spend and invest by thinking about what each of us individually cares about and what makes rational financial sense. The pitfalls described above have been well-documented and their foolishness all too obvious. But being aware of these mistakes, alas, isn’t enough. Rather, the real challenge is summoning the mental fortitude necessary to resist the influence of others—and focus resolutely on what’s best for our own financial future.
Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Breaking the Rules, In Our Own Way and Farewell Yield.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
I try to use my cognitive biases and other mental foibles to my advantage. I’m as susceptible to herding as anyone else, but I aim to surround myself with people who are smarter and wiser than myself so I am influenced in a positive direction (that’s one of the reasons I visit this site). And for me, being frugal is a point of pride. So I still unconsciously signal and show off, but I do so by flaunting my resourcefulness and ability to resist impulse purchases rather than my ability to spend a lot of money.
I was privileged to have lunch with Warren Buffett a few years ago. I mentioned the richest person in my small hometown (net worth about $40 million at the time) who lived in a house with a one car garage. Warren looked at me and said, “I have a two car garage!” I think he was kind of proud of that. I’m starting to believe a well-managed ego is part of the formula for financial success.
Solid articles like this make me think the key to teaching financial literacy may lie more with psychology than with economics. Pay yourself first, diversify, rebalance every so often, that may cover it for the vast majority of folks, and they would hardly have to do anything else.