Many financial stories have been vying for our attention since the year began. Last week, the Swiss National Bank ended its policy of suppressing the value of the franc. Meanwhile, oil prices have plunged below $50 per barrel, and political unrest is manifesting itself in many international hotspots. Any of these stories might be worthy of a Sunday column because they are likely to affect your investment portfolio and money managers in the coming months. However, two other items caught my attention.
A few days ago, someone walked into Bucky’s Express in Glendale, Ill., and purchased the winning Mega Millions lottery ticket worth $280 million. The odds of winning that lottery were 258,890,850 to 1. Nonetheless, millions of tickets were sold, including many in North Carolina. Nationwide, lotteries are a big business. In 2014, they drew in $70 billion in sales. Clearly, a lot of us play the lottery even though it is a losing proposition. We seem to have an innate urge to speculate or gamble.
In Akron, Ohio, Anna Younker is closing her bridal shop because sales have fallen dramatically. Back in October, Amber Vinson visited the store and was later diagnosed with Ebola. You might recall that Vinson flew to Ohio after treating an Ebola patient in Dallas. As a precaution, Younker temporarily closed her store, had it thoroughly cleaned, and offered discounts when she reopened it. Apparently, would-be brides and bridal parties have decided that it is safer to purchase dresses elsewhere. In all, there have been 10 cases of Ebola in the United States. Eight patients contracted the disease outside the country, two got Ebola while caring for an infected patient, and two died. There have been no new cases in more than three months.
Aversion to loss
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Although Ebola is a legitimate public health concern and warrants appropriate immigration and hospital protocols, our reaction to the outbreak has been completely out of proportion to the actual risk posed by the disease in the United States. Our survival instinct is an important protection, but it seems to create an aversion to loss that is often not supported by any actual threats.
What do an Illinois lottery winner and an Ohio bridal shop have to do with investing? And why isn’t this column about the big issues roiling the financial markets? Market volatility, financial crises, and political unrest come and go. In due course, the currency markets will settle down, and oil prices will rise again. Undoubtedly, there will be some big winners and losers. I’m sure that more than a few hedge funds, private equity funds, and even mutual funds will have been severely damaged by the soaring Swiss franc, the plunging price of crude oil, or the outcome of the next Greek election, while other investors will have successfully navigated the volatile markets.
The purchase of a winning Mega Millions ticket and Amber Vinson’s purchase of a bridesmaid’s dress are reminders of how poorly our brains are wired for assessing risk. We will go out of our way to stop at a convenience store to purchase a fistful of lottery tickets, and yet we will avoid entering a store where there is a zero probability of contracting Ebola. Most of us exhibit both of these biases. Of course, the risks we typically face when making financial decisions aren’t as remote as winning the lottery or as dire as contracting Ebola. Nonetheless, we are wrong more often than we are right when it comes to evaluating the prospects for making money against the risks of losing it.
Even the so-called experts don’t do a very good job of weighing risks of investing.
For example, not one of 22 economists surveyed by Bloomberg News between Jan. 9 and 14 expected the Swiss National Bank to get rid of its cap on the Swiss franc, and yet days later the ceiling was lifted. In short, our brains have built-in biases that tend to make us take on too much risk from overleveraging our homes, speculating on Internet stocks and buying lottery tickets. Conversely, we’ll convert all our stock holdings into cash after a market collapse, avoid flying on airplanes after a crash, and shun people or places with the remotest connection to Ebola.
To be fair, marketers and the media know how to prey on our biases. At the top of the North Carolina Education Lottery’s website, visitors are promised a second-chance lottery, a bonus drawing, a free ticket giveaway and a frequent player program tied to a debit card. All these messages are designed to exploit our risk-seeking bias, and state lottery programs aren’t the only businesses trying to exploit those built-in idiosyncrasies. Think back to the media headlines in October about Ebola. If you need a reminder, just do a Google search of “Ebola headlines” and hit the images tab. From the Huffington Post to the New York Daily News, the media encouraged us to be very afraid.
The same media and marketing practices will be at work when you tune into the Super Bowl next weekend. Mutual fund companies, brokerage firms, banks and insurance companies will either try to stimulate that part of your brain that’s inclined to gamble and/or prod that part of your brain that wants to get as far away as possible from a loss. I am sure that some broker will entice you with flashing screens and graphs soaring upward, and an insurance company will play upon your fears of death and disability.
As investors, we cannot build up our savings if we don’t take risks. Cash is helpful if there’s something you are going to purchase in the near future, but it won’t buy much in 20 years if it isn’t invested. Nonetheless, none of us (retail investors or professionals) are well-wired to invest rationally. As a result, I believe investors need to be systematic about their investment plans and diverse in their investment selections.
Diversification is key
Rather than letting our biases encourage us to invest heavily as markets soar or to sell everything when they swoon, it’s best to invest periodically, much like the monthly contributions to your 401(k). Because we have innate biases, and we don’t know with any certainty when stocks, bonds or real estate will soar or sink, we need to spread out investment across multiple asset classes.
Moreover, we don’t want to rely entirely on the domestic or foreign markets or on large or small companies. Diversification provides a bit of immunity from some of our misinformed instincts.
Unless this is the first time you’ve read the column, you know I am a proponent of low-cost index funds and broad-based exchange-traded funds (ETFs). Aside from their relatively low costs, these types of investment products tend to remove some of the emotion and bias from making investment decisions.
However, if you can’t resist the urge to speculate a bit with your money to catch the next big IPO or avoid the next disaster, set aside a small part of your assets for that purpose. There’s nothing wrong with buying a few dollars worth of lottery tickets or going into a casino with a limited amount of money.
Similarly, it’s OK to set aside 5 percent of your assets to see whether you can control your biases sufficiently to pick stocks or time the financial markets.
However, if you think you can pick the correct numbers at the convenience store, or if the nonexistent risk of contracting Ebola makes you fearful, you should not try your hand at active money management or market-timing.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/