NerdWallet's Smart Money Podcast: Behavioral Finance Mistakes That Hurt Your Portfolio and What “Good” Returns Look Like
Episode Release Date: February 24, 2025
Hosts: Sean Pyles, CFP®, Sara Rathner, Elizabeth Ayola
Guest: Johannes Harrison, Behavioral Financial Advisor and Founder of MoneyScript Wealth Management
Money Question Expert: Sam Taub
Introduction
In this compelling episode of NerdWallet's Smart Money Podcast, hosts Sean Pyles and Elizabeth Ayola delve into the intricate world of behavioral finance, exploring common mistakes that can hinder investment portfolios. With insights from Johannes Harrison, a seasoned behavioral financial advisor, and a practical money question segment featuring Sam Taub, listeners gain a comprehensive understanding of how psychological biases impact financial decisions and what constitutes “good” investment returns.
Understanding Behavioral Finance Mistakes
Behavioral finance examines how emotions and psychological factors influence individuals' financial decisions, often leading to irrational outcomes. Sean Pyles sets the stage by acknowledging the brain's role in sabotaging financial goals:
"Sometimes your brain can be your own worst enemy when it comes to making progress on your financial goals." – Sean Pyles [00:00]
Johannes Harrison elaborates on this by introducing key behavioral biases:
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Cognitive Dissonance and Anchoring [02:22]
- Cognitive Dissonance occurs when conflicting beliefs coexist, such as being excited about a stock's potential while simultaneously criticizing the company's products.
- Anchoring involves relying too heavily on the first piece of information encountered. For instance, seeing a house listed at $700,000 makes a subsequent offer of $650,000 seem like a bargain, even if it's not based on the home's true value.
"Investors do this with stocks all the time. Sometimes someone will buy a stock after their friend tells them how much money they made, and then the price drops..." – Johannes Harrison [03:50]
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Recency Bias [04:58]
- This bias leads individuals to believe that recent market trends will continue indefinitely. A booming market may convince investors it will never decline, while a downturn can instill a belief that it will persist.
“Recency bias is when we assume that what is happening is going to happen forever.” – Johannes Harrison [04:58]
- This bias leads individuals to believe that recent market trends will continue indefinitely. A booming market may convince investors it will never decline, while a downturn can instill a belief that it will persist.
Elizabeth Ayola emphasizes the prevalence of these biases in investing:
"This kind of behavioral bias can be seen across the range of interactions that people have with money. But some of the ones that cost us the most pop up in investing." – Elizabeth Ayola [04:06]
Strategies to Overcome Behavioral Biases
Johannes Harrison provides actionable strategies to mitigate the impact of these biases:
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Zooming Out and Focusing on Fundamentals [04:52]
- Instead of fixating on fluctuating prices, assess the intrinsic value based on fundamental analysis.
"The key is zooming out. Instead of focusing on the prices, ask yourself what's the value today based on real fundamentals." – Johannes Harrison [04:52]
- Instead of fixating on fluctuating prices, assess the intrinsic value based on fundamental analysis.
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Long-Term Planning and Emotional Detachment [07:17]
- Emphasizes the importance of maintaining a long-term perspective and not letting emotions dictate investment decisions.
"Investing is not supposed to be exciting. It's supposed to be like watching paint dry." – Johannes Harrison [07:17]
- Emphasizes the importance of maintaining a long-term perspective and not letting emotions dictate investment decisions.
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Adopting a Well-Defined Plan [09:56]
- Creating and adhering to a structured investment plan helps counteract impulsive decisions driven by emotional responses.
"Have a well defined plan and sticking to that plan in light of all of the information that will be coming to you." – Johannes Harrison [09:56]
- Creating and adhering to a structured investment plan helps counteract impulsive decisions driven by emotional responses.
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Utilizing Robo Advisors [12:54]
- Robo advisors can help maintain discipline by automating investment decisions based on predefined criteria, thereby reducing the influence of emotions.
"Robo advisors and algorithms can also help you from getting into trouble with allowing your emotions and thoughts get in the way." – Johannes Harrison [12:54]
- Robo advisors can help maintain discipline by automating investment decisions based on predefined criteria, thereby reducing the influence of emotions.
Personal Anecdote [15:25] Johannes shares a personal experience with recency bias when his robo advisor sold a stock that subsequently soared:
"I recently had a stock that was sold out of my portfolio because of my robo advisor... I can't believe I sold that stock. It just hit an all-time high in the news." – Johannes Harrison [15:25]
He reflects on the importance of maintaining a long-term strategy despite short-term fluctuations.
Money Question Segment: Evaluating Investment Returns
Listener Inquiry: Mary reached out with concerns about her investment growth:
"I have about $6,000 in my Wells Trade IRA and around $3,000 in my Wells Trade account. Since 2018, my $1,000 contribution has grown to about $2,000. Is that a decent return?" – Mary's Question [19:15]
Expert Response by Sam Taub:
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Assessing Returns [20:35]
- The S&P 500 averages a 10% annual return before inflation over the long term. Mary's 100% growth over seven years aligns closely with this average but is slightly below the market's typical performance.
"The S&P 500 has returned about 10% per year before inflation on average." – Sam Taub [20:35]
- The S&P 500 averages a 10% annual return before inflation over the long term. Mary's 100% growth over seven years aligns closely with this average but is slightly below the market's typical performance.
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Understanding Mutual Funds [22:15]
- A mutual fund is a diversified investment vehicle managed by professionals, offering exposure to various stocks and bonds.
"A mutual fund is just a publicly traded basket of stocks or other investments like bonds." – Sam Taub [22:15]
- A mutual fund is a diversified investment vehicle managed by professionals, offering exposure to various stocks and bonds.
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Optimizing Investment Strategy [23:42]
- If Mary seeks higher returns and is comfortable with increased risk, switching to a more aggressive mutual fund or an index fund like the S&P 500 could be beneficial. Index funds typically have lower fees and better align with long-term growth objectives.
"Switching to an index fund like that is probably a pretty cheap and easy way to accomplish the goal of getting more aggressive and seeking higher returns." – Sam Taub [23:42]
- If Mary seeks higher returns and is comfortable with increased risk, switching to a more aggressive mutual fund or an index fund like the S&P 500 could be beneficial. Index funds typically have lower fees and better align with long-term growth objectives.
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Tax Implications [24:49]
- Moving funds within retirement accounts like IRAs avoids capital gains taxes, whereas adjustments in taxable accounts may trigger tax liabilities.
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Aligning Investments with Goals [25:23]
- Understanding Mary's investment timeline and objectives is crucial. For longer-term goals, adopting a more aggressive strategy can leverage market growth while mitigating short-term volatility risks.
"If Mary's investing for a longer term goal than that, then her investment would probably have plenty of time to recover from a bear market." – Sam Taub [25:23]
- Understanding Mary's investment timeline and objectives is crucial. For longer-term goals, adopting a more aggressive strategy can leverage market growth while mitigating short-term volatility risks.
Conclusion and Key Takeaways
This episode underscores the profound impact of behavioral biases on investment decisions. By recognizing and understanding biases like anchoring and recency bias, investors can adopt strategies to maintain a disciplined, long-term approach. Utilizing tools such as robo advisors and aligning investment choices with personal financial goals further enhances the ability to navigate market fluctuations effectively.
Final Advice from Johannes Harrison:
"Recognizing that those emotions are real and asking yourself the question, am I about to make this decision based on my emotions, or am I making decisions based on facts and fundamentals?" – Johannes Harrison [10:27]
Listeners are encouraged to educate themselves on behavioral finance, develop a robust investment plan, and seek professional guidance to optimize their financial strategies.
Stay Connected:
For more personalized financial advice and to ask your own money questions, contact NerdWallet’s Smart Money team at 901-730-6373 or visit NerdWallet’s Smart Money Podcast.