Daniel Kahneman is a psychologist who won the 2002 Nobel Prize in economics. An interesting combination. How could that happen? Perhaps the stock market is psychotic. It is more likely that the people who invest there are not completely rational. We can and should learn from that.
All of the statistical material and techniques that assume a fully rational, fully informed trader are almost certainly imperfect. If you accept that, then learning to manage yourself may be as important or even more important than learning to manage your money. In the best case, you learn to manage yourself and learn to take advantage of a market where others have not learned that skill.
For advisers, learning to manage a client’s expectation is crucial. People do not compare their results to what is rational and objective, they compare results to their expectations.
If we go golfing and each arrives back home at 8:00 different things will happen. If I told my wife I would be home at 9:00 and you told your wife that you would be home at 6:00 we get asymmetric results from a single event. You would think that a single, objectively verifiable event would always generate the same outcome. Obviously not so.
When the outcome is not as expected, it is not the event that causes the problem it is the comparison to the expectation that causes the problem.
Be cautious about implicit expectations. While past performance does not imply similar future performance, that is not how people understand the world. All of us use the past to help us estimate the future. Recent events easily translate into expectations for the future. When current results are good it is especially important to emphasize that the past does not predict the future.
Suppose I meet you at a New Year’s Eve party. You decide to let me invest $25,000 for you, for a year, just to see what happens.
I do so, and a year later I am happy to tell you that your $25,000 investment is worth $1,000,000. You decide to let me continue for another year and at the end of that second year, your investment is worth $75,000.
I would be shocked if you introduced me to your friends as the person who tripled your money in two years, even though that is an exceptionally good result.
Write down this rule, “There is such a thing as a paper profit, but all losses are real.”
You cannot be a successful investor or a successful adviser if you cannot manage expectations and the resulting emotions that arise from events.
The same thing works for children too.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org
Follow on Twitter @DonShaughnessy