Kim Snider
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June 28, 2005

Controlling Your Emotions: The Stairway to Financial Heaven

Investing is a constant battle between your rational brain and your lizard brain. Study after study tells us that the reason the average investor has such dismal performance over time is that they make decisions upfront with their rational brain that their lizard brain cannot live with. In other words, what makes "sense" doesn't "feel right."

 

A novel approach to communicating risk/reward scenarios by Mitch Anthony called Stairway to Financial Heaven uses the following example to demonstrate the difference:

 

If there was a stairway to financial heaven and I offered you the following to climbing scenarios, which would you prefer? In scenario one, you would climb 10 stairs in an average year. In a bad year, you would tumble down 18 stairs. In a really good year, you would climb 38 stairs.

 

In scenario two, you would climb eight stairs instead of 10 in your average year, but you would only fall down six stairs in a bad year. In a really good year, you would climb 35 stairs. Which scenario most appeals to you?

 

Which one did you choose? If you are like most people, I am guessing that you chose the scenario which gained eight stairs in the average year, losing six stairs in a bad year and gaining 35 stairs in a really good year.

 

If that was the case, you just chose a 30/70 (stocks/bonds) asset allocation based on Ibbotson’s research on the historical movement of prices over a 50 year period. Surprised? This is the exact opposite of the traditional 70/30 asset allocation recommended to most pre-retirees!

 

Why would so many of us make such a conservative choice that is so different than the conventional wisdom? It's because by framing it in terms of the stairway analogy instead of numbers, you are asking your lizard brain to make the decision rather than your rational brain.

 

Your rational brain would say to take the traditional 70/30 allocation because, on average, you were going to make more. But your lizard brain processes this information emotionally. It intuitively understands that that is an awful lot of downside risk for just two extra stairs in an average year.

 

Investing isn't just about the probability of success. It is also important to take into account the magnitude of failure. The downside in a bad year in the 70/30 scenario is much more pronounced than the upside in a good year. In fact, there is three times the risk in a bad year but only 9% more gain in a good year.

 

Who would want to take a risk where the loss in the worst-case scenario was 30 times greater than the possible gain in the best case scenario? That feels more like Russian roulette than logic to our lizard brains.

 

Investing is a lot more than just return percentages and standard deviations. The key to success is not the path you choose, but rather your ability to stay that course for long periods of time. If your portfolio gives your lizard brain motion sickness, reaching your destination is pretty unlikely.

 

I believe advisors, investors, and financial engineers must take the behavioral considerations into account when designing financial products and putting them in individuals portfolios. You cannot ignore the lizard brain or it will surely sabotage the best laid plans.

 

What do you think? Did you pick the 30/70 asset allocation? How does that match up to your current asset allocation? What do you think the implications are for you? As always, I'd like to know your thoughts. Please leave your comments below.

 

PROPS:

 

1. Mitch Anthony, "Stairway to Heaven." Financial Advisor. June 2005. p 61-66, 171.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.

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