Jag: Welcome to our weekly podcast, the Art of Wealth Unbroken. We provide our listeners with insights and proven strategies to protect the wealth they’ve built against poor financial planning, investment mistakes, global and national economic conditions, and governmental policies. We discuss the topics in finance, retirement and politics that are on your mind, giving you certainty in uncertain times.
These discussions can help you make better informed decisions so you can make better financial choices with the wealth you’ve built and are continuing to grow. Our host are Stacey Andres, registered financial consultant and Michael Wallin, certified financial planner. I’m Jon “JAG” Gay and our topic today, we’re gonna discuss running in the wrong direction because that’s how we’re wired.
Michael: Hello JAG and hello Stacey. Today, we’re gonna discuss the phrase, “just stay the course.” And I know that there’s listeners on the show today that are sitting there saying that’s exactly what my broker dealer is saying today. That’s exactly what my financial advisor is saying today. We’re seeing a correction in the market that’s taking us down nearly 20% and we’re gonna discuss why that phrase may be correct. But it is also completely opposite of how the investor is wired.
Stacey: Okay. And so before listeners have a knee-jerk reaction, to today’s show topic. And whether we’re debating the merits between tactical investment and strategic investment approach, our discussions today are going to delve into the area of behavioral finance.
Jag: Wow. Yeah. I hope our listeners are sitting down or more so laying on a soft couch, maybe in an office, cuz this sounds like they’re gonna take a look under the hood at why our brain responds the way it does. I promise we’re not gonna go into like your childhood and mom and dad and all that, but take it away, Mike.
Michael: Jag, you’re absolutely correct. You would have to be living under a rock today, not to feel the impacts of a market contraction that has seen a little more than a 20% decline in pricing, recessionary numbers in the economic landscape and or global distress that is causing consumerisms to be in an imbalance with escalating inflation.
We hear that every day, every news cycle, every time the radio is on. We’re getting bombarded with those pressure points. With all of the negative stimulus, most investors are emotionally feeling the need to run. It is part of our fight or flight response. So when an investor hears the phrase, just stay the course, the market will return. That doesn’t always align with the emotional feelings they’re currently experiencing in behavioral finance.
Stacey: Mike, we call this the emotional dynamic of loss. Aversion loss aversion for our listeners. It is a cognitive bias that describes why for individuals, the pain of losing something is psychologically twice as powerful as the pleasure of gaining.
The pain felt from an asset, losing value, whether it’s a 401k, an IRA, an individual account, et cetera, or any other value of object can feel significantly worse, does feel significantly worse, than the pleasure of having an equal gain of that same amount.
Michael: Yeah. Loss aversion is what has caused so many investors to remain on the sidelines.
We all saw the contraction of the 2020 COVID correction. We saw the market on the S&P 500 drop all the way down to 2300 points. For those individuals that were sitting on the sidelines, they only looked to reinvest once the markets got back up to its peak point, which we saw that towards the end of 2021, but the market had already corrected back to around 4,600 points only to now see a correction in the cycle.
So they lost all of the upside of the market. Now they went back into the market only to get a second correction happen to ’em cause loss, aversion equates to lost opportunity.
Jag: It sounds like loss aversion could impact individuals in many different areas of their life.
Stacey: That’s exactly right. Jag, because it does have a systemic effect, meaning that it can impact every aspect of a person’s plan, not just the area that is drawing our focus right now.
Loss aversion can prevent individuals, corporations, and even countries really from making riskier decisions to address some complex challenges. Though risk aversion is important, it can also prevent the implementation of innovative and potentially riskier solutions.
Jag: All right, let’s take a quick break and then come back and discuss where these emotions come from ,what steps an investor can take to avoid the impact of loss aversion on their long range goals.
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Michael: So guys, where does loss aversion come from? Well, I started doing some research and studying in the behavioral finance, and I came across an article by The Decision Lab that I thought really defined this very well. Loss aversion is caused by a mixture of neurological makeup, social economic factors and cultural background.
Jag: That’s deep.
Michael: Yeah, well, it was way more than I was than my degree provides for me. So I thought I, I was glad they gave me the cliff notes on this.
Jag: Hey, I’m a communications major. I’m even further behind than you.
Michael: You know, there’s three specific regions of the human brain that become activated in situations and involving loss of version. So I don’t, we can talk about finances or you can apply it to any of those other systemic areas of a person’s life.
The amygdala is the part of our brain which processes fear. For example, the amygdala creates an automated pre conscious sense of anxiety when we see a snake, I don’t know about you guys, but I’m a country boy, and I do not like snake.
Jag: I’m a city boy, I don’t like them either.
Michael: The reaction we experience with loss in this part of our brain is similar to our brain’s response to when we react to an airplane turbulence or a spider, meaning fear or loss are closely related.
The second region that we look at in our brain that is active when we process a loss is the stratium. The stratium region handles prediction errors in our minds and helps us to become better in predicting. We call that our denominator, our past experience. You know, if you touched a stove in the past and it burns you, you’re probably not gonna touch the stove again, because we know that there was a negative impact to that.
Okay. The third area that we look at is the insula. And again, I’m not a medical. I may be butchering these names guys, but the insula area reacts to disgust and works with the amygdala. To make individuals avoid certain types of behavior. Neuroscientists have noted that the insular region lights up when responding to loss.
The higher the prospective loss, the more activated the insular area becomes compared to the equivalent gain. So in that, with what Stacey said earlier, When you have an experience that area lights up twice as great in a loss area than an equal benefit of gain. So if you lost $20, it’s gonna light up twice as great as if you had gained $20.
And that’s why. Your brain is telling you that staying the course is not the right approach because those three areas of the brain are coming back and telling you, we need to flee this situation. We need to avoid this situation. Neuroscientists are telling us that we need to avoid those behavioral conditions.
We do not need to allow those emotions to come involved in our decision making.
Jag: Just as a quick aside, Michael, one of my very dear friends was our high school valedictorian. She ended up becoming a neuroscience major and works in the medical field, outside Boston. I will confer with her and see if you got those names in the brain right.
Michael: If not, you’re the producer you edit in.
Stacey: That’s right. That’s right. So what’s interesting when you say that Mike, is that it’s true that an investor’s actions are often driven by these emotional dynamics that are coupled with the socioeconomic factors and cultural biases that they may have. I have read articles where emotional biases such as loss aversion can contribute to nearly a 2% reduction in annual returns to an investor’s account. If you take 2% and you compound that over a 20 year period of time before retirement.
Jag: Yikes.
Stacey: And then through retirement, it can mean whether or not that investor, our client has the ability to live the retirement dream that they’ve always dreamed of.
Or like you say, Hey, I have a desire to live in Hawaii, but my assets allow me to retire in Decatur, Alabama, something like that.
Jag: I mean, both are kind of tropical, but not quite the same.
Stacey: I’d prefer Hawaii.
Michael: Yeah. Loss aversion is real guys. This is something that when we’re sitting with clients, we are truly trying to help them to understand.
That they will have a tendency to run, right in the wrong direction when conditions trigger. The best way for us to help them avoid this is number one as an investor, you need to identify a seasoned investment advisor that you trust to counsel you through these uncertain times. We covered this interview and selection process last week. You need to have a written plan that already has built in expectancy of contracting markets. When a market contracts, it should not be the first time that you’re thinking about that. Advisors that only sell you on the bloom of the rose and never talk to you about any of the thorns on the stem are not actually counseling you. They are selling you.
And you need to have a trusted financial advisor that can tell you both about the aroma of the bloom, the beauty of the bloom, but the thorns are going to be a part of it as well. And you also need to have a strategy that is nimble and flexible in times of need.
Stacey: Mike, in addition to what you just stated there, having that in your written plan, I believe that any good plan, any good advisor should also have that discussion verbally with their clients together about how they are going to handle or manage that plan. When we find ourselves in a time like we are in right now, where emotions for so many people are what’s driving their decisions rather than the common sense or the logic of staying the course.
And so preparing for these type of times in advance of them occurring can go and does go a long way to help ensuring that we stay on track. Toward reaching the island of financial independence that we talked about reaching on our last show.
Jag: It’s so funny how counterintuitive all this is, how our brains tell us to run. And this is where having a great advisor, a great coach, can help you fight those natural instincts, which end up self sabotaging you again, going from Hawaii to Alabama in your retirement. That’s visceral for me because I would really like to retire in Hawaii someday. If our listeners want to come talk to the two of you about their financial future, about behavioral finance, about any of the stuff that we talk about in this show, they can go to our website, artofwealthunbroken.com.
Again, artofwealthunbroken.com is the website. Or the phone number is (855) 378-1806. Again, (855) 378-1806. Always a pleasure gentlemen, we’ll talk to you next week.
Stacey: Thank you, Jag.
Michael: Thank you, Jag. Thanks Stacy.
Thanks Mike.
