The study of finance and economics has undergone a radical shift in recent decades. Until recently, economic theory was founded on the idea that individuals are “perfectly rational actors” (that is, we always make rational financial decisions, based on all the knowledge available to us, that serve our economic self-interest). But newer economic research increasingly shows that our decisions are often guided by our emotions and our choices often lead to counterproductive results.
Spearheading this shift in thought has been the field of “behavioral economics,” whose champions have gone from being scorned initially to winning a Nobel Prize. Although not widely recognized or acknowledged, biblical truths underlie this secular research (more on that shortly).
We believe SMI members can become better investors by understanding their (often counterproductive) behavioral tendencies and learning how to moderate them by following time-tested investing practices rooted in scriptural principles. That’s why SMI weaves practical ground rules and biblical precepts into our investment counsel.
Here are three ways SMI addresses common behavioral issues that work against long-term investing success.
We set strict non-emotional selling guidelines.
Selling guidelines are a key defense against the endowment effect (valuing something more highly than you should simply because you own it) and sunk costs (the difficulty humans have parting with something they’ve invested in).Without the strong, mechanical selling disciplines built into each of our strategies (such as demanding top-quartile performance in Stock Upgrading and Sector Rotation), we’d be as prone as other investors to “falling in love” with certain investments after a run of success, or wanting to hold on a little longer hoping losing positions “get back to breakeven.” (See more on this topic in this month's article, Biblically Based Boundaries Help You Become a Better Investor.)
We urge readers to exercise restraint in strategy allocations.
To keep risk exposure below certain levels, SMI warns investors to limit allocations to “hisk-risk, high-return” strategies, such as Sector Rotation. Why hold back when there’s reason to believe such strategies will outperform over the long term? Because of the powerful behavioral trait of loss aversion, which causes investors to feel the pain of losses roughly twice as much as they enjoy the pleasure of gains.We recommend strategy diversification.
Using a combination of strategies is another way to combat loss aversion. Diversifying among strategies that excel in different market environments helps investors manage their emotions through the bull/bear-market cycle. That’s why we suggest blending strategies (as discussed in this month’s article, Beyond Bonds: Limiting Risk Within Long-Term Portfolios).
Even though the conclusions reached by behavioral economists in recent decades may have surprised the rest of the economics field, they shouldn’t have surprised anyone familiar with the Scriptures. After all, as we note in The Sound Mind Investing Handbook, the Bible speaks clearly about specific human weaknesses that affect us as investors:
Our wisdom is flawed:
“Do not deceive yourselves. If any of you think you are wise by the standards of this age, you should become ‘fools’ so that you may become wise. For the wisdom of this world is foolishness in God’s sight” (1 Corinthians 3:18-19).Our motivations are impure:
“The heart is deceitful above all things and beyond cure. Who can understand it?” (Jeremiah 17:9).Our emotions can overpower us:
“For I know that good itself does not dwell in me, that is, in my sinful nature. For I have the desire to do what is good, but I cannot carry it out“ (Romans 7:18).Our vision is limited:
“Now listen, you who say, ‘Today or tomorrow we will go to this or that city, spend a year there, carry on business and make money.’ Why, you do not even know what will happen tomorrow. What is your life? You are a mist that appears for a little while and then vanishes“ (James 4:13-14).
SMI seeks to combat the problems these weaknesses pose for investors by offering time-tested counsel grounded in unchanging scriptural truths. We also emphasize developing a stewardship mindset focused on growing wealth slowly but steadily.
To be sure, markets will always be unpredictable, and human nature will always tug investors in the direction of emotion-based decisions. So, even knowing these principles, investing will never be easy! But SMI investors can approach the task with confidence, assured that they’re applying God’s wisdom to the subject.
