ARROYO GRANDE, Calif. – Behavioral finance took center stage a few years ago when the Nobel Prize for Economics went to a psychologist. Behavioral finance is the psychology of investment decisions, a science that shows investors are irrational. The award should have killed off Wall Street's myth of the "rational investor."
Unfortunately, investors are still asleep: Most investors don't realize they're in denial. They still assume they're making rational investment decisions. Worse yet, most investors are not only clueless about being irrational, they're clueless about being clueless.
There are three reasons for this ongoing psychology of denial. First, many investors hate being irrational. Their weak egos need the myth of rationality. Second, Wall Street loves having investors trapped in the myth. A clueless investor is easy to manipulate when it comes to fees and commissions. The third reason is that most behavioral-finance books are dull, boring texts filled with jargon and cryptic formulas.
So here's my quickie 10-question behavioral-finance quiz. Maybe it'll help you become a little more aware of how you're trapped in denial, playing an irrational game which is controlled by Wall Street and your friendly fund industry. They write the rules and fix the odds in their favor, like a Vegas casino.
Here we focus on historical realities, avoiding short-term quarterly-report nonsense. Here are 10 facts Wall Street would rather you continue denying. These 10 facts will reveal the intensity of your denial. See how many of the 10 you can accept.
1. Regardless of the facts, you cannot admit failure
What causes failure? "Confronting Reality" co-authors Larry Bossidy, former Honeywell CEO, and management guru Ram Charan say: "The greatest consistent damage to businesses and their owners is the result not of poor management but of the failure, sometimes willful, to confront reality." Same with investors and governments.
2. The market loves making fools of everybody
Ask yourself: Does 2006 look good because the first quarter closed with the best gain since 1999? Or is it a sucker's rally? History's more important than quarterly reports. Looking back six years the market's a loser: the DJIA, Nasdaq and S&P 500 are still below 2000's record highs. In "Stocks for the Long Run" Jeremy Siegel studied history, the biggest up and down days from 1801 to 2000. His conclusion: Markets are random. There's no rationale for 75% of the moves that trigger most long-term gains or losses. Investing is unpredictable.
3. Optimism is the investor's worst nightmare
Morningstar put together some long-term price-to-earnings ratios for us: All nine fund categories and eight sectors, about 10,000 funds. Why focus on P/E ratios? Yale economist Robert Shiller did in "Irrational Exuberance," the psychological profile of 1990s mania. P/E ratios reflect optimism, your worst nightmare. Long-term, P/Es are still high. They've been under 15 most of the last century and peaked at 44.3 in 2000. They spiked over 15 twice before, once in the 1920s before the Great Depression. Again in the 1960s bull, before an 18-year sideways market. Today P/Es are 21.4, below the peak but still deceptively high. Are you overly optimistic?
4. America is like an addict who can't stop
In "American Mania: When More is Not Enough," psychiatrist Peter Whybrow says we're addicts; "more" really is never enough. Our savings rate is below zero so we borrow $67 billion a month to feed our addictive consumerism. We're insatiable, only crashing will stop us. If you're not saving 10%, you're spending too much.
5. Kids will rebel against their out-of-control elders
Kids rioting over labor laws in France; immigration in America. More ahead! In "The Coming Generational Storm," economists Larry Klotnikoff and Scott Burns warn us about the massive debt we're piling on our kids: Social Security, Medicare, government deficits, trade debt, corporate pensions, mortgages, credit cards. Our kids will rebel against the $70 trillion legacy created by today's reckless out-of-control spenders.
6. We're selling our power to Asia and the world
Thomas Friedman warns: "The World is Flat." And getting flatter and more competitive as the global playing field levels, according to "Three Billion New Capitalists: The Great Shift of Wealth & Power to The East." Back in his 1997 "Megatrends Asia," John Naisbitt predicted: "the 21st Century belongs to Asia." Our egos still can't accept that we're giving away our power, mortgaging our future, selling key assets, self-sabotaging.
7. Failure to plan for crises guarantees failure
In "Collapse: How Societies Choose to Fail or Succeed," geologist Jared Diamond shows that throughout history surviving cultures are always the ones that focus on long-term planning, well in advance of crises. Failed societies are the ones whose leaders "focus only on issues likely to blow up in a crisis within the next 90 days." Sounds like Wall Street's fixation with quarterly earnings or Washington rebuilding Category 3 hurricane-resistant levees.
8. 'Greed is still very good" ... for Wall Street
Vanguard founder Jack Bogle confronted the toxicity of greed in his "Battle for the Soul of Capitalism." So does Yale Portfolio creator David Swenson in "Unconventional Success." The problem is obvious: Despite all the scandals, Wall Street is sinking deeper into a culture of greed, where investors come second. And unfortunately, Washington and Corporate America back Wall Street, not you.
9. God, oil and skyrocketing debt don't mix
Former Republican strategist Kevin Phillips' new "American Theocracy" examines the rise and fall of great nations. Rome, Britain and others lost power following a convergence of three trends: diminishing resources, ballooning debt and militant religions. The mix creates a blind obsession for world domination, which ultimately self-destructs. Are we in denial, or is he?
10. You can't trust 'them,' they're lying to you
Here's a survival manual once you admit you're clueless and decide to get out of denial. Begin with this assumption: You cannot trust anyone out there, not Wall Street, not Washington, not cable, not ads, nobody. "They" are all trying to control your mind, spinning and lying all day. Skepticism wins. To survive, make "you" No. 1. Seth Godin's "All Marketers Are Liars" has a powerful yet inspiring message about focusing energies. It will change the way you think about reality, and the way you invest.
What's your score? Anything less than eight and you're definitely clueless, trapped in denial, clueless about being clueless ... and easily manipulated by Wall Street.
If you do see what's going on, then you can choose to either get out of denial and use the new concepts of behavioral finance to your advantage or continue letting Wall Street spin your cluelessness against you.
Copyright (c) 2006 MarketWatch, Inc.