The Path Of Least Resistance
Do you tend to act more like water or electricity?
Imagine a single electrical current that feeds two lights. The first light is a 60-watt classic incandescent bulb. The other is a modern 8.5-watt low-resistance LED (Light Emitting Diode). When a wire conducts current to both circuits at the same time, surprisingly, both lights brighten up! That is to say that electricity has no preference for the lower-resistance LED bulb.
In contrast, water always takes the path of least resistance. It never runs uphill, and if there’s an easier route, water will find it.
In our lives, the path of least resistance is the easiest road to travel, but a choice, nevertheless. We are more than capable of solving both simple and complicated problems; to venture down both low and high resistance paths. But it’s naturally appealing to use the least amount of effort.
Most people understand the effects of procrastination on their ability to complete tasks and reach personal goals. For example, say that you commit to a morning exercise regime before work. As the alarm jumps to life at six a.m., it’s easy to convince yourself to stay under the blankets instead of leaping out of bed into your shorts and runners. Procrastination is the preference for immediate rewards—the cozy bed—over future rewards—a fit body. Despite your best intentions, this bias persuades you to take the path of least resistance.
Beyond their impacts on fitness and other personal goals, common biases also influence the way you save and spend money. Biases produce errors in judgement, generate anxiety in your financial decisions, and many times, directly result in financial loss. Yet, despite the potentially harmful impact on your financial well-being, most people are unaware of the vast majority of these naturally-occurring human tendencies or when these behaviours occur.
Over the last three decades, I’ve been involved in behavioural finance research, both formally, as an adjunct professor at the University of British Columbia Okanagan, and practically, as a CFA charterholder and discretionary portfolio manager. It has been fascinating to observe the wide variety of ways clients formulate decisions during the emotional ups and downs of significant events such as the Asian, Russian, and Argentine economic crises of the 1990s; the September 11, 2001 terror attacks in New York City; countless energy calamities; acute weather events; the Great Recession of 2008, and the 2020 worldwide pandemic. Despite the variety of circumstances, I found that most investors are relatively consistent in their behavioural tendencies, following similar patterns when events recur. As markets drop precipitously, it became predictable which clients would call, who I’d need to reassure, and which people would be motivated to change their investment policies whenever volatility escalated.
It was also telling that when certain clients called the office with fear about the prevailing havoc in the investment markets, the timing of those calls was almost always at or near the trough of the market cycle. What I’ve learned over the last 30 years of managing people and their wealth is in this book.
Errors of judgement are not restricted to the urge to sell your investments at the bottom of a stock market decline. They crop up in your daily routines when you least expect them. They affect how much you spend, how much you save, and how you negotiate contracts. The instances that erode your wealth go largely undetected, with each of us commonly justifying these occurrences by attributing them to some other set of facts.
Consider how frenzied trading activity recently inspired by Reddit and other social media platforms pushed up the stock price of GameStop by a hundred-fold over a few weeks. The business prospects of the company were no better after its price skyrocketed than before the increase. Something else must be at work—something in the behaviour of the masses who participated—all believing that buying the shares was a good idea.
This isn’t the only example of investors willing to convince themselves that trading overpriced investments somehow makes sense. The justifications that we manufacture only serve to make us feel better about our moment-driven choices. The security is overpriced, yet we decide to buy it anyway. Then, we follow-up the transaction with another natural inclination, which is to confirm our decision. If the price appreciates after we make the investment, we believe this to be evidence of a wise choice. The rising price of an overpriced-stock, however, doesn’t change the fact that it is overvalued.
We use the same process to excuse a poor decision when the share price drops by blaming the loss on some external factor. There is always a handy justification at the ready. Either way, we want to feel that we made the right decision, whether it was a prudent investment or not.
There are many examples of judgement errors that don’t seem like errors at all. Take, for example, an investor who refuses to hold a certain a type of security because they lost money on such a trade in the past. Surely, it’s a good idea to avoid earlier mistakes, isn’t it? Yet relying categorically on this rule of thumb has limited this investor from participating in opportunities that may be suitable, profitable in the future, or otherwise provide important advantages.
Behavioural biases don’t only affect individual investments, but can also cause general patterns across the stock market as a whole. Investors’ decisions—inspired by common biases—can result in broad market changes. Collectively executed behaviour manifests in over-bought and over-sold stocks until enough individuals realize the error and abandon the buying or selling frenzy. Prices rise or fall much further than is warranted by fundamentals when biases distort our analyses and overrule our long-term strategies. Stock market prices can regularly become over-heated in a tide of euphoria, or be demolished by sweeping fear.
Academics have debated whether or not markets are efficient since stock analysis became a recognized profession. There is educated rationale argued on both sides. However, profitable investing boils down to one truth. If investors know all the reported information about a company and information is widely distributed, there should be little to dispute the value of any stock or any other investment. If the company’s shares trade below that value, a shrewd investor will buy them, pushing the share price up to that value until no further profit can be made. If the shares trade above this value, they sell it (or short it), pushing the price down to this value. If we all agree on the value of anything—through analysis—there would be little or no profit able to be made on trading it, beyond the internal growth of the business. But, in real life, it is much more complicated because people—and their prejudices and judgement—are part of the decision process. So, it is these prejudices and errors of judgement that provide another way to profit: when other investors are wrong and you recognize the error.
As we continue to increase our understanding of behavioural economics, investors can use that information to produce better decisions, reduce the stress in financial transactions, and increase long-term financial gains. As you discover the impact of certain conditions on your behaviour, you’ll become empowered to modify your choices and increase your opportunities to succeed.
This book is designed to help you identify how and when biases can undermine your financial decisions and how to mitigate the damage they cause. By determining your personal set of values and by building a long-term perspective of your goals, you can limit the number of financial decisions you will face, and in turn, lessen the effects of potential mistakes.
This book will also provide you with simple habits that you can incorporate into your lifestyle to avoid many of the pitfalls that you’ll learn. With these strategies, you can reduce your risk and limit the worry of economic losses.
Behavioural Economics is a relatively new field, yet the vast body of work has resulted in a dictionary-long list of behavioural terms. Many of these definitions are overlapping or interconnected, if not confusing. Moreover, many of the biases identified by research are tough to avoid in a meaningful or pragmatic way. To counteract this impracticality, I developed an overarching structure that puts the large number of recognized biases into three categories so that investors can more easily identify the underlying processes that effect their decisions.
Based on my experience, most of these biases fit into one of three primary processes:
- We rely on rules of thumb and other efficiency mechanisms to understand our world; these can distort our judgement.
- We try to vigilantly control risks, sometimes at the worst possible moment.
- We have a strong predisposition to believe that we are right, even if this belief is misguided.
A single bias is rarely the sole influence of our choice architecture. Our actions manifest from a variety of interacting biases at once. For example, the tendency to hold onto losing stocks and sell the winning ones is described by the disposition effect, loss aversion, and anchoring. The willingness to buy inflated stocks is tied to overconfidence, confirmation bias, and herd mentality. Each of these biases—and others—will be discussed in the pages to follow, organized by the categories listed above: Making Sense of What You See; Controlling Risk; and You Want to be Right.
Understanding when biases are present is important because they can seem deceptively logical. You may feel that you have determined your best option, however, the fundamental way that your brain manages data, with short-cuts and time-saving strategies, causes systematic problems that you may not recognize yet.
It is critical to first be able to identify which situations commonly interfere with your financial success. To that end, the first chapter describes a variety of scenarios where specific biases can cause distortions and judgement anomalies. The second chapter outlines how our attempts to control risk can undermine our goals and objectives. The third chapter illustrates a variety of ways that our deep-seated need to substantiate our decisions—prove that we are correct—alters our perception. In the stories ahead, you will likely relate to many of the examples because behavioural biases are startlingly consistent among all of us. You may recognize situations that you’ve been in, both past and present, and you may identify with the various decision-making processes. In any event, you’ll notice how simple, yet dastardly, these inclinations can be in undermining your financial success. The innocuous nature of these tendencies may even induce you to feel that you can avoid such errors in the future, now that you’re aware of them. That’s natural, and if you find yourself feeling that way, you’d be falling under the spell of another bias! Knowing is not enough, as you’ll discover during the investigation of the G.I. Joe Fallacy.
You can correct for many of these predispositions with the relatively simple habits that this book offers. If you’ve ever relied on an alarm clock, you’ve already applied a conventional technique to control your behaviour. Incorporating other habits in your lifestyle can similarly improve your financial success.
In addition to distilling the list of individual biases into the three primary patterns of errors, this work also serves up a single critical strategy to apply to all aspects of your financial affairs. By honing your choices to align with your values and long-term plans instead of making reactionary choices, you can reduce the number of overall decisions that you need to execute. This will reduce your exposure to behavioural biases, and reduce the stress of confronting such decisions, by reducing their frequency.
When you understand your motivations and your objectives, you can avoid considerable heartache over your lifetime. The only way to consistently integrate your values into your financial decisions is to know what they are first. Many people have a loose idea of what they value, but few people take the necessary steps to organize them into a practical and useable process. Through a series of eight activities, you will uncover your financial motivations and identify what is most important to you. These questions are developed from my experience working with individuals of all levels of wealth. Ultimately, the responses to each activity are driven by you.
At the end of the eight activities, you will have a tool that can help you achieve your most critical goals. Applying your Personal Economic Principles (PEP) to long-view decisions will limit the impact of herd mentality, loss aversion, and a host of other traps. The fewer times you change your mind, the fewer decisions you’ll make, and the less you’ll be subject to errors in judgement.
By engaging your Personal Economic Principles, you are empowered to reduce the stress of financial decisions because you can avoid transactional decisions and remain focused on what is most critical to you. These are the strategies that I have been helping my clients to implement for decades.
Calculated consistent choices aligned with your values will help you to behave like electricity, choosing your route, rather than flowing like water down the path of least resistance. Ultimately, you are pursuing your personal version of happiness. As the age-old question begs: Can money buy happiness, and if it can, how does it work? How much of it do you need? And how do you attain it? This summary offers insights into what you may have felt for years, backs it up with research, and distills it into effective habits that you can adopt in your life.
The objective of this book is to reduce your stress in financial decisions, produce more reliable outcomes, and limit your financial risks. While this book offers a generous helping of the knowledge that I have accumulated from working with a wide variety of clients, the information contained in these pages is not investment advice nor can it take your particular circumstances into account. If, by the end of this book, you find any product or service discussed appealing, I urge you to seek an investment professional who can explore whether such approaches are right for you. Also, I’d like to point out that the views set out in this book are well-researched from sources that I believe to be credible and reliable. I’d also like to assert that professional organizations that I work with now or have worked with in the past represent a wide body of individuals and opinions, and the conclusions of my work may not be held by these respected organizations.