The study of finance and economics has undergone a radical shift in recent decades. Until recently, the foundation of economic theory was that individuals are “perfectly rational actors” (that is, we always made rational financial decisions, based on all the knowledge available to us, that were in our economic self-interest). But newer economic research increasingly shows that our decisions are 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 initially being scorned to winning Nobel prizes. Recognizing the biblical truth that underlies this secular research (more on that shortly), SMI has a history of featuring articles by noted behavioral economists.
This month’s cover article is the latest example of our belief that SMI members can become better investors by understanding their behavioral tendencies.
Understanding these principles is important, but applying that knowledge is even more so. That’s why we continue to weave these principles into our strategies and investment counsel. Here are a few examples of how SMI addresses the specific behavioral issues discussed in this month’s cover article.
- Strict non-emotional selling guidelines.
These 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 until losing positions “get back to breakeven.”
- Exercising restraint in our strategy allocations.
As this month’s Level 2 column on Sector Rotation demonstrates, SMI suggests limiting your allocations to high-return strategies in order to keep risk exposure below certain levels. Why do that, when we have reason to believe those strategies will outperform over the long-term? Because of the powerful behavioral trait of loss aversion, which researchers have shown causes investors to feel the pain of losses roughly twice as much as they enjoy the pleasure of gains.
- Practicing strategy diversification.
Investing in a combination of strategies, as we discuss in the Level 3 year-in-review report this month, is another way we combat loss aversion. Diversifying among strategies that excel in different market environments can greatly aid an investor in managing their emotions through the bull/bear-market cycle.
The conclusions reached by the behavioral economics crowd in recent decades may be a surprise to the rest of the economics field, but they shouldn’t be surprising to us as Christians. After all, as we point out in The Sound Mind Investing Handbook, the Bible speaks clearly about numerous specific 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 Cor. 3:18-19).
- Our Motivations are Impure
“The heart is deceitful above all things and beyond cure. Who can understand it?” (Jer. 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“ (Rom. 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 tries to combat the problems these weaknesses pose for investors (along with their manifestations such as the endowment effect, sunk-cost fallacy, and loss aversion) by offering counsel grounded in scriptural principles and emphasizing a stewardship mindset focused on growing wealthy slowly but steadily. Investing, even when applying these principles, is never going to be easy. But we can approach it with confidence knowing we’re applying God’s wisdom to the subject.