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We Just Aren't Wired to Think about This Stuff

We Just Aren't Wired to Think about This Stuff

February 02, 2021

A Financial Planner has some Fun with Numbers...

In his best selling book “Thinking Fast and Thinking Slow” brain science researcher Daniel Kahneman considers how easily our brains are fooled.  First reactions are often flawed (this is his “Fast Thinking” brain), and his research shows that we humans very rarely question our first reactions, as we are usually quite convinced of our own rightness.  He uses many examples to show how even the most educated among us are often hoodwinked by their own intuitions and thinking shortcuts.  

He notes throughout the book how statistics and percentages are often the most difficult concepts for our “Fast thinking” brains to handle.  Yet, understanding these concepts is key to making sound financial planning and investment decisions.  Here are just two examples that occur to me.

Game Stop again? 

I just wrote yesterday about the insane trading in Gamestop.  From Jan 21 to Jan 28, the stock went up by 1071%.  In the 4 trading days since, the stock is down by 71%.  Without doing the math, just a quick guess, how much did the person who bought Gamestop on Jan 21 make if he sold today?   

The fast thinking brain will quickly compare the 1071% gain (really big number!) with the 71% loss (not so big number) and think that the gain the investor made must still be sitting on some really big gains, right?  The fast thinking brain will quickly compare the two numbers and assume proportionality.  But losses and gains are not comparable.  Since you can’t lose more than 100% (unless you are buying on margin, but that’s another story…) then a 71% loss is actually a really big loss.  In fact, the stock is still up, but is “only” up 210% (for now). 

This means that a $1000 investment made on Jan 21 was worth $10,071 on Jan 28 - but is now down to $2,100.  Worse, the poor sap who invested $1000 in GameStop at its peak on Jan 28 now has just $280 left.  Maybe AOC and Ted Cruz should be praising RobinHood instead of criticizing the firm for saving many potential investors a lot of pain. (The discount brokerage controversially halted buying of the stock last week during the feeding frenzy, drawing the ire of the two publicity hounds on Twitter.)  

Here’s another one which is more relevant to most of us in our own financial planning. 

An investment in stocks has returned an average of about 9% per year over long periods of time.  Most casual investors know that.  Let’s say we compare that investment to a more conservative investment that will earn 6% per year.  The expected return in stocks is about 1/3 higher return than the more conservative investment.  Many risk averse investors will end their thinking (Fast Thinking) there and opt for the less aggressive investment.  The additional 3% isn’t enough to make up for the angst they might feel as the stock market experiences one of its inevitable periodic downdrafts. 

But let’s say that investor is 30 years old, and won’t need this money for another 35 years.  What is the real difference between the two investments?  $10,000 invested at 9% return for 35 years will grow to a staggering $204,000.  In contrast, the same money in our 6% investment would grow to only $77,000.  When comparing the expected end results, the stock investment isn’t 1/3 better (33%) than the more conservative investment, but almost 3 times (300%) better!  The difference in retirement lifestyle afforded is dramatic.  Maybe worth taking a little more risk looked at this way?

Perhaps one of the benefits of working with a financial planner is that we can help make sure your decisions are based on good sound "slow thinking".   

(past performance is no guarantee of future results, and this is purely a hypothetical mathematics exercise, not an investment recommendation)