Are You Rationalizing an Investing Mistake?

MARK RIEPE: What do you need to be happy?

I bet every person in every culture that has ever existed has struggled to answer that question.

The ancient Greeks took a pretty good crack at it. “Know thyself” was one of the first maxims inscribed at the Temple of Apollo at Delphi.¹

There’s a good reason this topic has been discussed for centuries. Everyone is different. Knowing who you are, knowing your limits, knowing your guiding principles, and knowing your goals can help you navigate many of the obstacles of life.

But there’s a catch when it comes to knowing thyself. In Poor Richard’s Almanack, Benjamin Franklin wrote “There are three things [that are] extremely hard: steel, a diamond, and to know one’s self.”²

Knowing yourself isn’t just important for everyday life—it applies to investing as well.

Some investors know they can’t handle the stress and worry of a risky portfolio. Some know they want to focus on early retirement and require a certain level of return to get there.

But putting together a strategy that connects our goals and our temperament and sticking to that strategy over the long haul takes serious commitment and discipline.

And it’s made more challenging when the past experiences we or our family and friends have skew our perceptions, or when real-world market news is popping up on our phones nonstop, distracting us from taking a longer view.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.

If you save money and invest it consistently, your path toward meeting your goal seems simple. But anyone who tries it quickly discovers that there are hurdles in the way, and one of those hurdles is our own brains. There are many types of hurdles or decision-making biases that can hold us back. But, today, I’m going to focus on four that we’ve discussed on previous episodes—recency bias, status quo bias, affective forecasting, and confirmation bias.

But rather than review academic studies about these biases, I thought it would be more useful to discuss how these biases sound. I’ll be speaking with two of our Schwab advisors who work with all types of investors every day. One interesting perspective from them is the warning signs they see just before someone makes a poor decision. In particular, what do investors sound like in the moment? What sorts of things do some investors tell themselves in order to justify their actions?

Joining me now are Brad Bartick and Joanna Heckman. Brad manages the Schwab branch in downtown Denver, and Joanna is a financial consultant and CERTIFIED FINANCIAL PLANNER™ certificant. They have decades of experience working with clients and their portfolios, and this is, I believe, the second Schwab podcast for Brad. You were on WashingtonWise Investor with Mike Townsend last year. Welcome to you both.

JOANNA HECKMAN: Yeah. Thanks so much for having us, Mark.

BRAD BARTICK: Yes, great to be here.

MARK: I want to ask both of you about four different biases, in other words, four different hurdles that people have faced recently. And the first one involves the pandemic. You know, 2020 was an extraordinary year in many ways. We saw that many people were engaged with their financial life like never before. But that’s recent history, and our perspective right now is one that tends to favor recent events over historical events. This recency bias, if you will, it manifests itself in lots of different ways, but how did you put 2020 into historical context for the investors you worked with?

BRAD: So, Mark, we know that recency bias happens when we place more value on recent information than we do other information. And what we saw last year from investors was this belief that the COVID correction, and I’m talking about the March 2020 timeframe, was going to last way longer than it actually did. What does this sound like? I had a client tell me, “My friend is a doctor, and he said half the population could be wiped out.” And I remember thinking, “Well, how would you ever invest if you believe that?” So all you can really do is try to arm people with reliable data about how the markets had reacted to other big historical events. You know, how long did those corrective periods last? How severe was the low point? How did different types of portfolios fare during that timeframe? And the hope being that the information helps people be maybe a little bit more realistic and also maybe a little bit more prudent when they’re making decisions.

JOANNA: Yeah, Mark, I remember the fever pitch that was reached in that late March 2020 timeframe by many investors, kind of being led by the news cycle. People, speaking of this recency bias, were convinced that the market would continue the extreme volatility that we experienced really throughout that month of March. And there was speculation about not how many months, but how many years the recovery might take. Well, obviously you can see us here a year later, and while 2020 will go down in history, the market ended hovering near all-time highs. It was definitely one of those years where the market did not do what people thought that it would do.

MARK: What we wanted to do on this episode is to talk to the two of you about what that sounds like when speaking with investors. In other words, what things do you hear them say that might inadvertently reveal their state of mind? When does a phrase like, I don’t know, “I’m just waiting for the dust to settle”—when does that come into play?

JOANNA: It comes into play when investors’ emotions are heightened, and it’s often by circumstances that are outside of their control. So I think the investor’s instinct is to freeze or to become paralyzed. When things feel as uncertain as they did in early 2020, I think the temptation for investors is they start to tell themselves that there will come a time at some point in the future that they will feel more confident putting some cash to work or in addressing their investing strategy. The problem with that, though, is that the idea of letting the dust settle means that you’ll feel comfortable once you’ve collected more information, but often the market processes that information much more quickly than we do. 2020 was a unique year, in that we weren’t just dealing with the pandemic, but we also went through a political season. So in terms of this idea of metaphorical dust, 2020 definitely had a lot of it.

BRAD: Well, I see that phrase come into play when people should be making a decision that they’re not thrilled to have to make. And a lot of times they’re not thrilled to make the decision because they feel like they don’t have a solid grasp of what’s happening, so they don’t have a solid understanding from which to make the decision. People will come to these decisions, or they’ll come to these status quo positions—like “I’m waiting for the dust to settle” or “I want things to calm down.” And I really do like asking clients, “Well, what if you’re wrong? You know, what if the thing that you think is the safest is actually the most costly decision of your sort of near-term investing life?” Because when people can talk out loud and they can process and be challenged, I really do think it leads to better decisions.

MARK: One thing I’ve observed in stressful situations is that some people freeze. They want to stick to the status quo and not make any decision. On the other hand, others have a bias towards action. They feel they need to do something, anything. Brad, what do you typically see?

BRAD: When people are afraid, there’s this tremendous urge to take action. I mean, it’s almost impossible to resist. “I’m afraid of something, and I need to take action. And what is that action going to be?” That action might be to do nothing. You know you might be in cash, and you might be thinking, “This is a great time to enter.” But you might be super anxious, so you don’t. So that status quo has this fantasy aspect of being this safe position. But what is safe in the short term, or what feels safe in the short term, is often very detrimental in the long term. You know, staying out of the market for a prolonged period of time, especially if it’s volatile, and especially if you got out while it was volatile, that is a wicked cycle that typically ensues. And trying to get out of that framework from there, it’s really difficult because you need more and more confirmation that it’s really safe to get back in. But the problem is, is it never feels that way, and so you end up not being invested during periods when you really should have been.

JOANNA: What I think investors are thinking about at that point is, “What if things do get worse, and I could have sold today and I didn’t make that decision?” I think Brad makes a good point to say, “What if I am wrong?” I think that what we know is the fear of loss becomes more painful, or the actual loss becomes more painful than missing out on the upside. And clients get into a mindset where they just feel like they don’t want to lose anymore.

MARK: Joanna, another phrase I hear a lot is “This time is different.” It’s usually used to justify some investing strategy because of a belief that long-term historical patterns, they no longer matter because of something that happened recently. Did you hear that from investors in 2020?

JOANNA: Sure, we did, and in many ways it was different, because it was this extraordinarily different set of circumstances than any of us have ever lived through. I work with 95-year-old investors, and many of them said that this was a completely different year than they had ever experienced before. In 2020, we lacked a whole lot of clarity at the beginning of the pandemic, and there was a whole lot to be pessimistic about. People were making themselves experts on the coronavirus. What started to happen, though, was we began to get some good news pretty early on. The government stepped in with stimulus, there was more information about a timeline for the vaccine, and the Fed started to ease monetary policy significantly. So while many investors remained on edge and perhaps paralyzed, the market started to process this information and this better or good news, but the people who left the market were still waiting for their chance to get back in because that window was so short.

BRAD: You know, that’s a common statement, “This time is different.” And you hear it a lot, but it’s not really about the statement being right or wrong. I mean, big unexpected events—they always feel different, and they always feel a little bit crazy. You know, it’s normal that people would kind of have that reaction. What I try to remember is that, eventually, it always comes down to the same thing, and that is what are you going to do in the face of an event like this? You know, we sometimes say people can be scared for a lot longer than the market will be scared because people take a lot longer to process all of the variables that, ultimately, drive the market back up, you know, or rebound. You know, I can only say it is moments like that that make me appreciate, you know, how vital it is that people own high-quality investments in a diversified portfolio. And I know that sounds, you know, maybe a little bit wooden or maybe a little bit cliché, but those types of frameworks, those types of portfolios, eliminate a lot of second guessing.

MARK: So what do you do about that? What are you suggesting to clients that they think about when you hear that kind of reaction?

JOANNA: I was just going to say, I think another thing that came into play was this idea of having an emergency fund in a year like 2020, and many people who had followed that investing principle had cash on hand to weather whatever the market was going to bring in the short term. That provided people a lot of peace of mind.

BRAD: That’s why it’s so vital, I think, to own high-quality investments in a diversified portfolio. It just results in a lot less second guessing. You know what you own, you know why you own it, and you feel safe in staying the course.

MARK: One of the standard questions that is asked of investors to help them figure out the risk tolerance is how they’ve behaved in the past during volatile periods. And that really kind of is a nice lead into the third bias or hurdle I want to ask you about, and that’s affective forecasting. And this is relevant for investing because one of the standard decisions an investor needs to make is to project how they will react when markets get volatile. Are there situations where people say, “I can tolerate a lot of risks,” but when markets start to get choppy and big swings in prices are no longer just theoretical possibilities, then they go ahead and forget the high-risk preference they said they had when you spoke about it during calmer periods?

JOANNA: Let me give you an analogy about this one, Mark, because Brad and I are skiers here in Colorado, and I can speak from personal experience about risk tolerance and how there’s a difference between talking about your ski day as you’re driving up in the warm car and when you’re actually standing over the face of a double black diamond thinking, “Why am I taking this much risk? What’s my plan for getting down this that doesn’t include a broken leg?” And I think risk tolerance in investing is similar. Accepting risk feels easier when you’re making the decision against a calm and seemingly stable market as a backdrop. So having said that, I’d encourage investors to consider a couple things. What have you actually done in the past when you’ve encountered volatile markets? And that may require you to pull up old trade confirms or old statements and actually take a look. While I think I might have done nothing, did I actually sell when things really got volatile? Your tendency will, of course, be to repeat past behavior. Also, I would recommend taking a look at your financial plan and actually considering what risk—and, therefore, return—is needed to get you to your goals. Going back to the ski analogy, why go white knuckling down a double black diamond if skiing down the blue groomer gets you where you need to be?

BRAD: I think this has to be one of the toughest parts of the job. And I wonder a lot about this. I mean, you know, the question is can a person really know in advance how they’re going to react in a risky situation, because risk tolerance, it seems to change as market conditions change. The theory is that it shouldn’t, but Joanna can attest to this, that it does. You know, we can ask people, “How did you react in the past? So there was a choppy market period in the Great Recession. Walk me through some of the decisions you made. How did you feel? What did you do?” Things like that. But people’s memories aren’t very reliable, and they do fade with time.

So I think the answer to your question is really kind of a two-parter. You know, the first part is, yeah, have a healthy conversation about risk before you start investing, at least level-set in some way before you begin the process. But people really need to have somebody that they can talk to when the actual risk is happening, and, you know, that person has to be somebody that’s objective, someone that’s unemotional, someone that’s intelligent. Even folks in the business need support during those times to make good decisions. You know, we need a voice, we need someone there, you know, to kind of steer us back in the right direction. I think that’s a super important component to managing risk in your portfolio and your financial life.

JOANNA: I think another thing clients should think about is risk comfort versus risk tolerance. Tolerance implies that we’re taking on the absolute maximum risk that we can handle, whereas comfort, actually, may get you to your goals. While you may have more left at the end, if you take on more risk, if it strips you of all peace of mind and drives you crazy watching the market volatility in the meantime, then what was it all worth?

BRAD: I’d also say, Mark, that there’s a lot of, what do they call, Monday morning quarterbacking when it comes to market events. So, you know, people are sort of gripped with terror when you see the Dow down 2,000 points intraday in March of 2020, and you’re frozen. But if you talk to those same people now, all they will say is, “I should have. I should have. I should have.” “If only I had. If only I had.” So that sort of speaks to that idea that there’s these sort of two frameworks of risk. There’s what would my intent be when I’m clear-headed, and then what are my actual actions when I’m in the thick of battle? And it’s reconciling those two things that is so critical to success.

MARK: The last bias I want to ask you about is one that I think is the most difficult to handle. I’m talking about the confirmation bias. I know I suffer from it, and I suspect most people, if they’re being honest with themselves, suffer from it, as well. How does confirmation bias most frequently manifest itself when speaking with investors?

BRAD: Yeah, this is a really tough one, and we know what this is, it’s this tendency to overvalue the things that match what we already believe and to undervalue, you know, information or opinion that doesn’t match what we want to believe. And in terms of how this manifests itself in investors, it happens in many ways. I’d probably say nowadays, like right now, I think it’s pessimism. You know, I notice a lot of pessimism in the discussions I have with clients. And I’ll tell you, you know, forget about what side of the political spectrum you’re on, I think most people would agree that pessimism is just prevalent in the world today.

And, you know, as this relates to confirmation bias, well, you know, the pessimist seeks out information that reinforces pessimism. And, you know, to each their own, but investing, unfortunately, is an act of optimism, not pessimism. You know, the core premise of investing is that the world will be better tomorrow than it is today, therefore, you know, I want to take part in the growth of what happens between where we are now and where we will be. And my confidence is placed in the dollars that I place into the stock market, or the bond market, or just an investment plan.

JOANNA: And Brad just touched on it, but I think an obvious area where we saw this in the last year was politics. All of us, if it’s not us, we have a friend or a family member who only seeks out information that reinforces their political beliefs. They go to the news media, the podcasts, the articles that confirm what they already believe to be true. And this provides comfort to people. You know, we all like our truths reinforced, but the risk to investors and the way that this can manifest in the portfolio is it can lead to lack of diversification, it can lead to concentrated positions in companies that you feel like you know or are comfortable with, it can lead to lack of diversification across sectors, because perhaps there are certain areas of the market that we seek out information that confirms that this is the best area to be invested. And that can leave gaps in investors’ portfolios.

MARK: Joanna, I talk a lot about financial plans on this show as a way really of controlling many different biases. Where do you see that fitting into the picture?

JOANNA: Yeah, Mark, what I think we’re really talking about is trying to avoid emotional decision-making, which often leads to attempts at market timing. A disciplined investing process, starting with a financial plan, is the answer to that. In my experience, the investors who have the highest likelihood of avoiding these pitfalls understand why they are investing. They’ve created a plan and they understand the steps that they need to take to stay on track or to get on track. And whether it’s a legacy they’re looking to create, whether it is travel or hobbies that they’re excited to pursue in retirement, or just kind of general security, the investors who have the most peace of mind, and, ultimately, the best returns are connected to their financial purpose beyond portfolio returns.

BRAD: I think, too, Mark, along with Joanna’s points is that, you know, when people … and I know your listeners probably recognize this behavior, even in people in their, you know, small circle, or their family, or, you know, their workplace, when people believe really strongly in something, there’s this desire to activate that feeling in other areas of your life. And investing is an easy one. So if I’m convinced that the future is dark, you know, that the country is heading in a terrible direction and we will not recover from it, I’m going to try to activate that feeling in my portfolio by either not participating, or dramatically reducing my participation, maybe talking to other people and trying to tell them the same thing. You know, we have this vested interest in our position being right. And that’s where confirmation bias is such a … you know, a tough thing to deal with. I mean, some of the listeners could imagine, try talking some folks out of their position on something like politics, or just the state of the world, it’s really tough. And, again, that’s where Joanna and I, what we work hard to do is just let’s just separate if we can a little bit from the events of today and just think about, you know, something like the last 100 years. Just look at a chart, you know, see how many tough events there have been and how many have not sunken the ship. You know, are you really that confident that now is a terrible time to invest?

MARK: We spent a lot of time talking about, you know, biases and mistakes that investors make, but what’s the other side of the coin here, what are the … kind of the habits and mindset that you’re seeing from the people who get it right?

JOANNA: As a financial consultant at Schwab, I work with clients across the spectrum, from self-directed to totally managed, you know, hands-off. I’d say that those who have the most peace of mind are for the most part engaged in some type of partnership, but they are individuals who recognize that they could benefit from taking a bit of an arm’s length approach to the portfolio, having some discipline in the times that it really gets tough, because we all know money is emotional. It’s hard to have that discipline as it relates to your own money. So those who really are the most successful long-term, I don’t even think that they look at their accounts more than perhaps once a week, because they know that their tried-and-true strategy will get them to their goals. I also think that the clients who are most successful have a connection to “What’s the portfolio all for? Why am I doing this?”—understanding if it is a legacy goal or a goal of financial security or a goal to be able to travel and pursue their hobbies in retirement, they have a real connection to the purpose of the portfolio.

BRAD: I’ll give my answer, but it’s sort of what Joanna said at the end. So, Mark, I think it’s about the why. I think that people who invest the best and make the smartest decisions, they know what it’s for, you know, they have a crystal-clear sense of where this goes. They know what success looks like, feels like, smells like, tastes like. I mean, again, this is a journey, and those decisions that happen along the way support this journey. And the roadmap is a financial plan. You know, your perspective as an investor is totally different when that why is strong and it’s supported by an actual plan—knowing how much you have to save, knowing how long you’ll have to work, seeing the fruits of wise investment decisions, you know. You know what happens with every paycheck, with every mortgage payment, every deposit towards your child’s education. You know there’s this grand vision at work, and it’s the thread that binds all of those near-term decisions together.

MARK: That’s a great point. Thanks for stopping by today, Brad and Joanna. You’ve given us a lot of great stories and information.

JOANNA: Thanks, Mark.

BRAD: Thank you.

MARK: I started off this episode with a couple of proverbs. There’s a lot of wisdom in proverbs. The proverb is usually providing what seems to be common-sense good advice. But there’s also a problem. Many proverbs have an antithesis. In other words, there’s another proverb that provides advice that’s the exact opposite of the first proverb. Let me give you a few examples. I’m sure you’ve heard that the early bird gets the worm or that you should strike while the iron’s hot. Makes a lot of sense. But wait a minute—we’re also supposed to recognize that slow and steady wins the race and that good things come to those who wait. So which is right? This isn’t an isolated conundrum. Who argues with look before you leap? I suspect it’s the people who came up with “Fortune favors the bold.” I’ve told my kids many times that it’s better to be safe than sorry, but I’ve also told them as many times, “Nothing ventured, nothing gained.”

The problem is that these platitudes are kind of like mental shortcuts. They’re like the decision-making heuristics or rules of thumb we’ve talked about on past episodes. They make sense, but we don’t want to rely on them too much. The reason is that a platitude isn’t the same as detailed advice when it comes to investing, and they certainly aren’t a strategy that’s customized to your needs and your situation. When an investor says, “I’m waiting for the dust to settle,” it can be thought of as kind of a shorthand that reveals the investor’s state of mind.

For the four biases we talked about today, most of them have mitigating strategies. To combat confirmation bias and recency bias, it helps to have a knowledgeable person who can serve as a sounding board. Use this person to bounce ideas off of and play devil’s advocate with your arguments. If you discuss your thoughts in detail with them, it can often reveal an emotional basis rather than a logical framework for your intended decision.

And that emotional basis can be tricky. We know that people have trouble forecasting their own emotions. Because of that, when confronted with that unexpected emotion, people can make poor choices that go against what their calm, rational self was planning to do. One fix is to use technology. Just as you can automate the contributions into your 401(k), some automated investing solutions can manage your portfolio. Some of these approaches can literally take the decision out of your hands and leave it up to the rules and algorithms you’ve selected. To learn more about Schwab’s automated solutions, check out schwab.com/intelligent.

Finally, I want to go back to the place we started: know thyself. Simply knowing your investment goals, your personal reasons for investing, and your ability to handle risk can help you stay on track. In the heat of the moment, it’s easy to forget all of those things. Make sure these are written down somewhere so you can refer back to them before you make a major financial decision. While you’re at it, keep in mind one other maxim from Delphi: “nothing to excess.” It sounds to me like an early warning against overly concentrated portfolios.

Thanks for listening. That’s it for today’s episode. If you don’t have a financial plan or it’s been a while since you’ve looked at yours, consider starting a new one at schwab.com/plan. As I mentioned, having clearly defined goals can help ground you during uncertain times. If you’re on Twitter, please follow me @MarkRiepe, M-a-r-k R-i-e-p-e. We’d also appreciate it if you could leave us a rating or review on Apple Podcast. We’d love to hear from you there.

For important disclosures, see the show notes and schwab.com/financialdecoder.

¹ https://en.wikipedia.org/wiki/Know_thyself

² https://quoteinvestigator.com/2017/09/04/self/