Avoid behavioural mistakes that trip up financial planning

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How can investors protect themselves against some common mental mistakes? Joining me to discuss that topic and to discuss his latest book is Brian Portnoy. He is the author of The Geometry of Wealth.

Brian, thank you so much for being here.

Brian Portnoy: It's great to be here, Christine.

Benz: Former Morningstar analyst. You've written a few books so far and the latest, The Geometry of Wealth, is really a personal finance book, and you attempt to help investors think about their goals, you attempt to help them find a way to simplify their financial lives a little bit with an eye toward those goals. 

In your work you focus a lot on behavioural finance and some of these behavioural mistakes that we all make as we go about our financial lives. I'm hoping we can cycle through some of the common ones that you think can trip investors up in managing their finances. You say not starting at the beginning is a big problem with a lot of people.

Portnoy: We tend to pay attention to things that are right in front of us. It's just the way we are wired, and it make makes a lot of sense. When it comes to money and investing, what's right in front of us--the market. The ticker across the bottom of the screen, the splashy headlines. We collectively as investors become attracted to the day-to-day noise. I think the biggest mistake that most investors, most people make actually, is not starting at the beginning of the process.

The beginning of the process is not beating the market or figuring out stocks or bonds or anything like that. It's taking a step way back and looking in the mirror and asking the big picture questions as to, what am I trying to do with my life, what is really going to make me happy? I develop a concept in the book called funded contentment …

Benz: And I love that.

Portnoy: Thanks.

Benz: Let's talk about what that means.

Portnoy: It's the idea that what we're really trying to do the question that we're really trying to answer is, am I going to be OK, are my family and I are going to be OK. To get at that--that's really not a money question first, that's a broader philosophical question--we want to find contentment through our community, through our ability to determine our own life's path, through being good at a job, and being connected to something bigger than ourselves. The frustrating part is that we can think about those pie-in-the-sky philosophical issues, but money comes into the story inevitably. We need to underwrite the sources of meaning in life. That phrase "funded contentment" is there to help people capture that notion that--focus on contentment but recognize that from a practical point of view you need to get your money house in order to get there.

Benz: This concept of funded contentment obviously what makes me content is not necessarily what makes you content. How would you advise people to go about thinking about what contentment they are seeking and then how they might get their finances to align with that?

Portnoy: You're correct to suggest that there's not a recipe or one-size-fits-all. This is a personal exploration. Different important factors will vary throughout the course of your life, whether it be the type of community you participate in, your connection to others. The effort and seriousness that you put into your career, your vocation, the flow that you find, your ability generally to write your own story and chart your own course.

If you go through a little bit of reflection about your life, you'll realize, well, those kind of come and go and they ebb and flow and there's different relationships between those various forms of contentment. We shouldn't try to think of this as an algorithm. We should try to think of this in terms of--our story is changing through time, and we are the authors of that story. We are in control, where do we wanted to go. Once we have that, then we can sort of dive into the financial planning part and have a really great base for what we want to work on.

Benz: I think an important component of this is that what people around me are doing or defining as contentment for themselves, I should not use that to guide my own contentment. If my neighbor is putting in a sprinkler system, I don't necessarily have to do that unless I really don't want to water or really prioritize green grass, right?

Portnoy: Absolutely. Social connections define the human experience. That's a really positive thing. The negative edge to that is that we look around to others for validation. We feel envy and jealousy. That's a really hard thing to transcend. But we have to remind ourselves that one person's path isn't ours. We can certainly look for others that we want to model because they seem to be doing things right. That doesn't need to be the way we go. Charting your own story is the key or at least the first step on the road to funded contentment.

Benz: Another thing that I want to talk about is the difference between having goals, having financial goals, and having a plan. You say that this is another thing that can trip people up, that they maybe just get to the goals piece and don't translate that to a plan?

Portnoy: Unfortunately, this exercise is a little harder than it might seem. If you think about goals, we can probably agree on the big ones for most people in terms of having a nice home, paying for your kids' college, retirement. Retirement is obviously the big one. Great to have those goals. In fact, a lot of people don't even think about them. But having a goal is not the same thing as having a plan.

To say that, generally, I want to save and over time I will have some money in the bank to pay for stuff as it comes along, there's a lot of levels of financial planning that can really increase the likelihood that you're going to meet those goals if you take them seriously as opposed to just having them simply on a piece of paper.

Benz: And you've got to prioritize goals too, right, because you might have goals but they may not all be achievable?

Portnoy: Absolutely. I think the prioritization that many people don't think about as much as they should is risk or risk management. Part of the way our brains are wired is that we actually achieve a higher level of happiness or deeper sense of contentment from minimizing regret as distinct from maximizing joy. We are naturally loss-averse creatures. A $100 of loss is twice as painful as a $100 of gain is pleasurable. That principle of loss aversion whether we like it nor not, drives our decisions and how we respond to the outcomes that stem from those decisions as we think about the things that can go wrong and I'm not just talking about buying insurance for your house. 

I am thinking about how you plan in your career; do you want to be an employee versus and entrepreneur. All those sorts of big topics thinking about risk first is a great way to minimize regret and that kind of clears an open space for you then to really pursue aspirational goals.

Benz: Thinking about risk minimization, not just in the context of my portfolio, although it's important there, but in other aspects of my financial life?

Portnoy: Risk sounds like a technical word that applies just to portfolios and investments. I'm talking generally about the possibility that things don't go according to plan, which we all know that they do, right? It's really about adapting to life's twists and turns when things don't go as you expect. But putting some thought into your relationships, into your career, into your community, and OK, where do I want things to go and just taking a little bit of time to think, if this doesn't go as I'd like it to, what's my reaction going to be.

Benz: Being thoughtful about all of your allocations, not just your money allocations but your time allocations, human capital allocations, and everything else.

Portnoy: Yeah. Time capital and human capital, something you've written about a lot, are really important forms of capital. We sometimes don't like assigning capital to those things. But they are things that we invest in, that we grow over time and that can be used to so-called purchase other things that we want. So, we got to take them really seriously.

Benz: Yeah. One topic that comes through loud and clear in the book--which I love and I'm a big believer in myself--is the idea of not getting bogged down in complexity, trying to simplify. You say that that's a common error that you see people fall into that they think if I'm working on financial stuff, it's got to be complicated. Let's talk about that.

Portnoy: Big topic. Really big topic. The market is very complicated. Stocks and bonds and funds and ETFs and all of the vehicles that we might invest in. There's almost an incentive in the market to make things complicated. We have the opportunity to fight back. The fact that we might find investments and insurance and other elements of financial planning to be complex, that's totally fine. But we have to …

Benz: It is.

Portnoy: It is, but we can cut through. One thing I do in the book is talk about a few very basic principles or ideas for simplifying our investment life. I firmly believe that what we are trying to do with our portfolios specifically is achieve our expectations. We need to set and manage expectations. When we say, I want to beat the market, or I want to choose a manager who is doing better than others--honestly, those aren't totally appropriate expectations. What we are really trying to do is fund contentment. We want our portfolio to be tied to our goals, not arbitrary benchmarks. Our life is the benchmark, the market is not the benchmark.

As a result, there are some basic things that we can focus on in terms of return potential, how volatile an investment has been historically and things like that. Volatility, for example--you will hear Warren Buffett and others say, volatility isn't risk, it's just permanent loss of capital. Respectfully, I'll disagree, because when markets get choppy, when our investments go up and down, we are much more likely to sell at the bottom. As a result, we bolt from our portfolio and we are left out of the market when it rebounds, and we are much less likely to achieve our goals. Volatility is a form of emotional risk that we should take very seriously.

Benz: The book is built around geometric shapes. You touched on two components of the square which you discuss in the book. You talked about volatility as well as growth or return potential. Let's talk about the other two corners of that square and why it's important for investors to keep those in mind when they are thinking about their investment portfolios.

Portnoy: Let's keep in mind that the theme here is simplifying the complex. Four corners of the square, four principles to set expectations. In addition to growth potential and emotional volatility we also have something I call fit. I think wonks would call it correlation. Correlations from a technical perspective are unstable, and there's a lot of details behind the scenes there. What we need to do as individual investors is just think about, OK, if I'm going to add something else to my portfolio, does it fit, am I just doubling up on something that I already have? We tend to shop for the same things over and over again. So, when we go to Costco or Nordstrom …

Benz: Totally. Black pants or …

Portnoy: Yes. Black pants for one. We keep buying them over and over again. We do that with our investments. It's like, oh, I really like the themes in this investment. I love growth stocks. I don't need just one fund. I need four funds that do the exact same thing.

Benz: I see that a lot. 

Portnoy: We tend to then believe that we are diversified because own four growth funds instead of one, but all we've done is quadruple our exposure to the same stocks.

Benz: And add complexity.

Portnoy: And add complexity. Line items in a portfolio is not diversification. Much of the times it's actually just more complexity. 

The fourth corner of the square is what I call flexibility. The wonky term would be liquidity. What I'm really talking about is the ability to change your mind. We are on this adaptive quest to fund contentment. Life doesn't always go as planned. As a result, you need to pivot from time-to-time. When it comes to our portfolios, are we able to change our mind, and can we move out of harm's way when we sense that it is coming, or can we move toward opportunity? 

One thing that I wouldn't want to leave investors with the impression is that total flexibility is a great thing. We don't want to trade every moment of the day. Having that sort of flexibility is not a great thing. People in retirement accounts who have a preset allocation and every paycheck they are chipping away, they tend to have better outcomes precisely because they don't have flexibility to move out of the way immediately when something happens in the market. It's not a question of more flexibility or more liquidity is better. It's a question of--you have a plan that you want to stick to, how much can you change it on a moment's notice and is that a good or a bad thing and that's a very personal decision.

Benz: And that's the fourth corner of that square?

Portnoy: Correct.

Benz: Brian, so many great insights in this book. Thank you so much for being here.

Portnoy: It's a pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.