I’m putting the finishing touches on the first edition of the new Behavior Gap Newsletter. The newsletter will be the place where you can find exclusive content and new sketches that haven’t been published anywhere else. If you haven’t signed up yet, you can still sign up here.  The newsletter will go out Thursday morning and I’m looking forward to getting your feedback.

The Behavior Gap is not just a problem for individuals. I was reviewing some old posts and ran across this one about the Yale Endowment fund. At the time I was doing some work for a large university endowment and was surprised at how eager, almost anxious, they were about finding alternative investments of any kind.

I remember specifically having the conversation in a committee meeting where they asked me, “What is Yale doing?” I also remember one of the members telling me that they were going to invest in a pool of distressed loans because he was a banker and “understood that most of the risk was behind us” (late 2007…we know how that turned out).

Well, this is old news, but in 2009, despite the Yale envy, its endowment suffered a loss of 25%. Harvard was down almost 27.3%. (According to one survey the average endowment lost 18.7% for the same time.)

Both were due in large part to “problems with their private equity and hedge fund portfolios.” The thing everyone else was trying to get in on ended up costing them shortly after. The worst part about it is so much of the money rushing to be like Yale got in too late. Not only did they take it in the shorts, but they missed the ride up before the fall.

This is a very painful lesson that has been playing out on campuses across the country as departments are closed and jobs cut. Granted this is only one year, and Yale has done well for years. It’s one more example of how emotions (greed) can drive us to make poor investment decisions even when we are on a University Endowment Investment Committee.

Past performance is no guarantee of future performance, yet how many of our decisions rely on what happened in the past? At the New York Times we’re discussing what we risk when we anchor our decisions on past value. This habit hurts us most when it comes to how we think of money. We can’t let ourselves get caught up in the idea of what we “think” something should be worth versus what it’s actually worth.

The Mental Anchor of Money Mistakes (New York Times)

[UPDATED]

MIT finance professor, Andrew Lo recently told a story about Richard Feynman, the Nobel Prize winning physicist. According to Lo, Feynman was speaking to a group at Cal-Tech soon after the 1987 crash and said:

“Can you imagine how hard physics would be if electrons had feelings?”

Think about that for a moment…we often approach investing as if it was some sort of physical science. We often act as if we are dealing with unbreakable laws like gravity when we make our long-term projections about the future, for example, the idea that if I take more risk (invest in stocks) I WILL get more return.

Well, the reality is that investing is NOT physics because markets have feelings.

In fact markets are nothing more than the representation of our collective (often irrational) feelings, and that is a far cry from some cold hard spreadsheet that says that 82.375% of the time stocks do better than bonds. So when we say that if you buy and hold stocks you will earn more money over the “long-term” than if you put all your money in CDs, we should end by saying, “We think.” We really don’t know for sure because there are so many variables that impact what will happen in the future including billions of humans and their feelings.

That is one of the reasons investing is so hard and most of us have had a disappointing experience. We build our plans based on the idea that there are rules but the market doesn’t seem to be following the same rules. In the real world it appears that the stock market might not even be aware that the rules created by economists even exist.

The fact that investing is not ruled by a set of natural law like physics leads me to be more cautious. Not just now, but always. It might be a good idea to keep in mind the old Will Rogers saying, “Don’t tell me about the return on my money, tell me about the return of my money.”

Conflicts of interest are inherent in the traditional financial services industry. Ignoring that the conflict exists doesn’t accomplish much. Life gets even more messy when you have been led to believe that the relationship is something other than “Let the buyer beware.” At the New York Times we’re discussing what this conflict means to you as an individual and why you can only expect disclosure and nothing more.

Learning to Live with Conflicts of Interest (New York Times)

Whether your flipping channels or browsing through a magazine, at some point you’ll come across snippets of financial advice. By itself, the advice isn’t dangerous, but how you choose to apply it can be. At the New York Times we’re discussing how relying on general financial advice can be dangerous to your financial health. How do you decide what you need to do?

Special thanks to Dylan Ross at Swan Financial Planning for his suggestion on how to improve this sketch.

Ignore Generic Financial Advice (New York Times)

How has your life changed since the economy went south? Have you changed your spending habits? Have you saved more? At the New York Times we’re debating the need to rethink how to best fix our economy. The answers aren’t simple, nor are they fast acting. Ultimately the fix starts with each of us assessing our relationship with money and what we’re willing to do to fix the problem.

The Great Debt Reset (New York Times)

Why invest in stocks? Because the potential return is greater than cash or bonds, but it comes with increased risk. At the New York Times, we’re discussing how market fluctuations and timing (market cycles) impacts whether we’re benefiting from that risk (bull market) or paying the price for that risk (bear market).

One Big Thing We Don’t Know About Stock (New York Times)

No one wins elections by delivering painful medicine that’s critical to avoiding a catastrophe coming at an unknown date and having unimaginable consequences. Regardless of what you think about Paul Volcker, you have to respect him for continuing to deliver the tough medicine.

Overconfidence is a huge problem when it comes to making investment decisions. In fact, it’s a huge problem when we’re dealing with any issue that has an unknown outcome. It’s clear that we’re very bad at dealing with unknown outcomes, but the biggest problem is that we actually think we’re good at it.

We think that we can control much more than we can, and we can actually forecast the future. Often we point to what we view as clear evidence and wonder how anyone that doesn’t see it the same way can be so stupid. Other times we base this superior ability on what we call a “gut feeling.” Then, every once in awhile, we turn out to be right (pure chance), and we remember that for a long time as say to ourselves and anyone that will listen to us:

“I know it all along.”

“I have a really good feel for these things.”

“I just think the market is going to go up.”

“It feels like things are clearing up.”

No where is this problem more evident than amongst economists. The recent deluge of “Crash Porn” books has given us ample insight into the painful consequences of being overconfident in pet models or Nobel prize-winning research.

For those of us with real lives who don’t have the time (or the interest) to read all these books on the crisis and it causes, a recent post on the Wilmott (a quant research firm) blog provides a nice review of many of the most popular “crash-lit” books written recently.

For those of you that are even too busy enjoying your lives to read the article, here’s a few interesting quotes from the post that sum up the entire thing:

• P.J.O’Rourke described economics as “an entire scientific discipline of not knowing what you’re talking about.”
• Unfortunately in the prediction stakes no economist can claim the prescience of Pope Benedict XVI. According to Italian Finance Minister Giulio Tremonti (as reported on Bloomberg News (20 November 2008)), the Pope, then merely Cardinal Joseph Ratzinger, in an article written in 1985 predicted that “an undisciplined economy would collapse by its own rules.” It is unclear which crisis the Holy Father was predicting, but given papal infallibility, probably all of them.
• Warren Buffet observed that: “…not only does a sky-high IQ not guarantee success but it could also pose a danger…I therefore urge the relevant regulatory bodies of the United Studies and Canada to incorporate an IQ test into their securities licensing exams. … nobody would be allowed to work in the financial markets in any capacity with a score of 115 or higher. Finance is too important to be left to smart people.”