Personal Finance is Not Rational

No One’s Crazy - Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works

— [Morgan Housel][1]

Lottery Tickets

Every decision people make with money is justified by taking the information they have at the moment and plugging it into their unique mental model of how the world works.

Those people can be misinformed. They can have incomplete information. They can be bad at math. They can be persuaded by rotten marketing. They can have no idea what they’re doing. They can misjudge the consequences of their actions. Oh, can they ever.

But every financial decision a person makes, makes sense to them in that moment and checks the boxes they need to check. They tell themselves a story about what they’re doing and why they’re doing it, and that story has been shaped by their own unique experiences.

Take a simple example: lottery tickets.

Americans spend more on them than movies, video games, music, sporting events, and books combined.

And who buys them? Mostly poor people.

The lowest-income households in the U.S. on average spend $412 a year on lotto tickets, four times the amount of those in the highest income groups. Forty percent of Americans cannot come up with $400 in an emergency. Which is to say: Those buying $400 in lottery tickets are by and large the same people who say they couldn’t come up with $400 in an emergency. They are blowing their safety nets on something with a one-in-millions chance of hitting it big.

That seems crazy to me. It probably seems crazy to you, too. But I’m not in the lowest income group. You’re likely not, either. So it’s hard for many of us to intuitively grasp the subconscious reasoning of low-income lottery ticket buyers.

But strain a little, and you can imagine it going something like this: We live paycheck-to-paycheck and saving seems out of reach. Our prospects for much higher wages seem out of reach. We can’t afford nice vacations, new cars, health insurance, or homes in safe neighborhoods. We can’t put our kids through college without crippling debt. Much of the stuff you people who read finance books either have now, or have a good chance of getting, we don’t. Buying a lottery ticket is the only time in our lives we can hold a tangible dream of getting the good stuff that you already have and take for granted. We are paying for a dream, and you may not understand that because you are already living a dream. That’s why we buy more tickets than you do.

You don’t have to agree with this reasoning. Buying lotto tickets when you’re broke is still a bad idea. But I can kind of understand why lotto ticket sales persist.

And that idea—“What you’re doing seems crazy but I kind of understand why you’re doing it.”—uncovers the root of many of our financial decisions.

Few people make financial decisions purely with a spreadsheet. They make them at the dinner table, or in a company meeting. Places where personal history, your own unique view of the world, ego, pride, marketing, and odd incentives are scrambled together into a narrative that works for you.

Experience Influences Us Profoundly

In Depression Babies: Do Macroeconmic Experiences Affect Risk-Taking?, Ulrike Malmendier & Stefan Nagel find that:

risky asset returns experienced over the course of an individual’s life have a significant effect on the willingness to take financial risks. Individuals who have experienced high stock- market returns report lower aversion to financial risks, are more likely to participate in the stock market, and allocate a higher proportion of their liquid asset portfolio to risky assets. Individuals who have experienced high real bond returns are more likely to participate in the bond market. While individuals put more weight on recent returns than on more distant realizations, the impact fades only slowly with time. According to our estimates, even experiences several decades ago still have some impact on current risk-taking of older households.

Our results are consistent with the view that economic events experienced over the course of one’s life have a more significant impact on individuals’ risk taking than historical facts learned from summary information in books and other sources.

Malmendier and Nagel also note that other studies have found a similar correlation between recent investment experience and investment choices:

In the context of financial decision making, Kaustia and Knüpfer (2008) find that the returns investors experience on their own investments in initial public offerings (IPO) are positively related to their future IPO subscriptions. Greenwood and Nagel (2007) show that young mutual fund managers chose higher exposure to technology stocks in the late 1990s than older managers, consistent with our finding that young individuals’ allocation to stocks is most sensitive to recent stock-market returns. In a similar vein, Vissing-Jorgensen (2003) shows that young retail investors with little investment experience had the highest stock-market return expectations during the stock-market boom in the late 1990s.

Other papers include circumstantial evidence consistent with the view that personal experience matters. Piazzesi and Schneider (2006) report that in the late 1970s old households expected lower inflation than young households. Young households apparently had a stronger tendency to extrapolate from their recent personal experiences of high inflation. Malmendier and Tate (2005) find that corporate managers who are born in the 1930s (“depression babies”) shy away from external sources of financing, and Graham and Narasimhan (2004) find that those who experienced the Great Depression as managers choose a more conservative capital structure with less leverage.

Even John Bogle Invested Actively

Jack Bogle, the late founder of Vanguard, spent his career on a crusade to promote low-cost passive index investing. Many thought it interesting that his son found a career as an active, high-fee hedge fund and mutual fund manager. Bogle—the man who said high-fee funds violate “the humble rules of arithmetic”—invested some of his own money in his son’s funds. What’s the explanation?

“We do some things for family reasons,” Bogle told The Wall Street Journal. “If it’s not consistent, well, life isn’t always consistent.”

Rational Does Not Help Us Sleep at Night

What’s often overlooked in finance is that something can be technically true but contextually nonsense.

In 2008 a pair of researchers from Yale published a study arguing young savers should supercharge their retirement accounts using two-to-one margin (two dollars of debt for every dollar of their own money) when buying stocks. It suggests investors taper that leverage as they age, which lets a saver take more risk when they’re young and can handle a magnified market rollercoaster, and less when they’re older.

Even if using leverage left you wiped out when you were young (if you use two-to-one margin a 50% market drop leaves you with nothing) the researchers showed savers would still be better off in the long run so long as they picked themselves back up, followed the plan, and kept saving in a two-to-one leveraged account the day after being wiped out.

The math works on paper. It’s a rational strategy.

But it’s almost absurdly unreasonable.

No normal person could watch 100% of their retirement account evaporate and be so unphased that they carry on with the strategy undeterred. They’d quit, look for a different option, and perhaps sue their financial advisor.

The researchers argued that when using their strategy “the expected retirement wealth is 90% higher compared to life-cycle funds.” It is also 100% less reasonable.

Housel also introduced Rick Guerin, Warren Buffett and Charlie Munger’s forgotten partner.

Buffett called Guerin one of the best investors I’ve ever met and referenced his returns in his article The Superinvestors of Graham-and-Doddsville. However, he was wiped out in the 1974 bear market. When asked about Rick, Buffett responded “Rick was just as smart as us, but he was in a hurry.” Buffett bought Rick’s Berskhire stock at under $40 a piece.

To take this even further, it isn’t rational to hold more cash than we need to because we are missing out on higher expected returns from putting this cash into the market.

No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff. Say cash earns 1% and stocks return 10% a year. That 9% gap will gnaw at you every day.

But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year—it could be many multiples of that, because preventing one desperate, ill-timed stock sale can do more for your lifetime returns than picking dozens of big-time winners.

Irrational But Good Advice? Love Your Investments

There is, in fact, a rational reason to favor what look like irrational decisions.

Here’s one: Let me suggest that you love your investments.

This is not traditional advice. It’s almost a badge of honor for investors to claim they’re emotionless about their investments, because it seems rational.

But if lacking emotions about your strategy or the stocks you own increases the odds you’ll walk away from them when they become difficult, what looks like rational thinking becomes a liability. The reasonable investors who love their technically imperfect strategies have an edge, because they’re more likely to stick with those strategies.

There are few financial variables more correlated to performance than commitment to a strategy during its lean years—both the amount of performance and the odds of capturing it over a given period of time. The historical odds of making money in U.S. markets are 50/50 over one-day periods, 68% in one-year periods, 88% in 10-year periods, and (so far) 100% in 20-year periods. Anything that keeps you in the game has a quantifiable advantage.

If you view “do what you love” as a guide to a happier life, it sounds like empty fortune cookie advice. If you view it as the thing providing the endurance necessary to put the quantifiable odds of success in your favor, you realize it should be the most important part of any financial strategy.

Invest in a promising company you don’t care about, and you might enjoy it when everything’s going well. But when the tide inevitably turns you’re suddenly losing money on something you’re not interested in. It’s a double burden, and the path of least resistance is to move onto something else. If you’re passionate about the company to begin with—you love the mission, the product, the team, the science, whatever—the inevitable down times when you’re losing money or the company needs help are blunted by the fact that at least you feel like you’re part of something meaningful. That can be the necessary motivation that prevents you from giving up and moving on.

Resources and References

[1] The Psychology of Money by Morgan Housel

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[2] Depression Babies: Do Macroeconmic Experiences Affect Risk-Taking? by Ulrike Malmendier & Stefan Nagel PDF