Why do people knowingly follow bad investment strategies?
I won’t ask (in this post) about why people hold foolish beliefs about investment strategies. I’ll focus on people who intend to follow a decent strategy, and fail. I’ll illustrate this with a stereotype from a behavioral economist (Procrastination in Preparing for Retirement):
For instance, one of the authors has kept an average of over $20,000 in his checking account over the last 10 years, despite earning an average of less than 1% interest on this account and having easy access to very liquid alternative investments earning much more.
A more mundane example is a person who holds most of their wealth in stock of a single company, for reasons of historical accident (they acquired it via employee stock options or inheritance), but admits to preferring a more diversified portfolio.
An example from my life is that, until this year, I often borrowed money from Schwab to buy stock, when I could have borrowed at lower rates in my Interactive Brokers account to do the same thing. (Partly due to habits that I developed while carelessly unaware of the difference in rates; partly due to a number of trivial inconveniences).
Behavioral economists are somewhat correct to attribute such mistakes to questionable time discounting. But I see more patterns than such a model can explain (e.g. people procrastinate more over some decisions (whether to make a “boring” trade) than others (whether to read news about investments)).
Instead, I use CFAR-style models that focus on conflicting motives of different agents within our minds.
The Benefits of Avoiding Responsibility
Implicit decisions are easier to rationalize away than are decisions that are clearly deliberate.
Any investment decision creates a risk that I’ll regret it later, and that I’ll lose status by being responsible for the decision, or by being evasive about it. That may even apply to “no-brainer” choices, since there is always a third option that might turn out to have been much better.
I have often wasted too much mental energy remembering and feeling guilty about mistakes I made in the distant past. Yet I rarely do this for mistakes that consist of procrastination (my attention was elsewhere when I made those mistakes, causing the mistakes to be poorly remembered).
Similarly, when talking about my investment decisions at a social event, I feel less embarrassed to admit that I ignored a decision than to admit that I carefully deliberated about a decision and then made a bad (in hindsight) choice. Presumably that’s because I can blame the former on system 1, whereas when system 2 was clearly in charge, the blame falls on mental processes that I more clearly identify as “me”. And maybe deliberate decisions provide better evidence about the quality of important decisions I’ll make in the future. At least it feels like everyone believes that, so it must be true, even though I forget why it’s true.
This effect seems especially strong where getting the decision right doesn’t demonstrate any high-status skill (e.g. when I carelessly borrowed money at higher rates than necessary).
Could it actually be rational to avoid responsibility? After all, I’m motivated by real benefits in my desire to brag about my successful decisions and to avoid talking about my mistakes. Maybe it’s somewhat rational, but I’ll bet that being dishonest with myself about what I’m doing impairs my ability to analyze my decisions.
One approach that has helped me reduce these problems is to organize my memory so that I’m mediocre at remembering most specific investment choices in contexts unrelated to my normal work. E.g. in most social contexts, I have some trouble remembering what trades I’ve been making recently, or what my biggest investments are, or what business company X is in.
When I’m actually focused on analyzing the market, I have plenty of software tools to remind me of the relevant facts. And in contexts where the facts feel like they matter, my mind is fairly good at recalling the facts.
Whereas when I’m at a party, I deliberately avoid caring whether I can remember which companies I’m currently invested in, or whether the market declined last week. I mostly prefer to talk about broad, long-term strategic decisions such as diversification, low volatility, etc.
That focus means I’m less affected by vivid mistakes, because I bundle decisions into large packages, whose average has few mistakes (compared to the ~50% mistake rate of individual trades), and because I can spread out responsibility for the decision so that no single action is a spectacular mistake.
That works for choices I make frequently, such as deciding which individual stocks to buy. But it works poorly for unique, one-time decisions (such as buying bitcoin once and then holding it for a long time). Which means it’s of limited value to the average person, who shouldn’t be trading frequently.
Ideally, we should reframe procrastination as a deliberate decision for which we feel responsible. And treat it as evidence that predicts how wisely our future selves will prioritize our attention. Social groups which encourage that attitude ought to be more productive.
But it feels hard to do that. Writing this post has helped me to want to reframe how I think about my procrastination, but I’m unsure whether I’ve made much progress in that direction.
Economists often claim the costs of changing one’s investments are small, based on the time it ought to take, and on an estimate of how valuable that time is in terms of lost wages.
But common behavior suggests that the relevant costs vary much more than is suggested by the opportunity cost of the time. I experience large differences in how stressful it is to interact with different institutions, especially unfamiliar ones. I’m probably doing something irrational in the high-stress situations, but I expect that there are real costs to fixing that irrationality, and those costs are relevant to investment decisions.
When examined in isolation, it seems fairly rational to attach importance to these transaction costs. But I expect I subconsciously overestimate these costs when I have other questionable motives for procrastinating.
Once I’ve made a mistake (either an instance of procrastination or a choice that hindsight says was bad), that discourages me from paying attention to the topic. The parts of my mind that control my attention get negative reinforcement when they draw attention to an unpleasant fact like this, so they learn to draw my attention away.
I try to limit this by intentionally telling myself I’ve done something right when I succeed in noticing those mistakes. I suspect this has helped, but I don’t have clear-cut examples of success to report.
The endowment effect is another important part of the problem. I haven’t come up with anything new to say about it.
How much does it matter whether I’ll be wealthy a few decades from now? And how much do investment choices affect my future wealth? Answers to those questions influence how much attention I devote to making wise investment decisions.
I answer them by imagining (in a way that generates some system 1 awareness) the value of compounding
and the benefits of being wealthy.
I can easily imagine scenarios in which future wealth doesn’t matter: AIs take over the world and make it a utopia or wipe out humanity; or a universal basic income provides nearly anything I need to be happy; or my savings go to waste when I’m cryopreserved.
But I can also imagine scenarios in which wealth makes a big difference: The Age of Em scenario, where being able to control when I’m uploaded might increase by orders of magnitude how much life I can experience. I’ll say there’s a 2% chance of this (the combination of the em scenario and my wealth enabling me to be an em), which seems pretty important to my system 2, but leaves my system 1 indecisive.
The somewhat more likely (but less interesting) result is that nothing revolutionary happens to the world for decades, and that I get modest benefits from wealth until I’m cryopreserved. That sounds unimportant when I compare it to the scenarios of the prior two paragraphs. But a more appropriate comparison is to what else I could do, given this scenario, to improve my wellbeing. Most things that I can do this year to improve my life 20 years from now are things I’ve already made a habit of doing, or things that are less cost-effective than wise investment decisions at improving my distant future.
I’ve mostly talked about how we as individuals can improve our own rationality. But many people care more about improving the rationality of distant strangers, so I’ll say a little about possible government policy changes.
What could persuade people to take more responsibility for their actions?
- A National Rebalancing Day, when everyone is expected to make some sort of change to their investments. Banks and brokers are required to send a message to customers who don’t, saying something like “You have decided that you like how your assets are invested”.
- A stronger version of National Rebalancing Day, where banks and brokers are required to make some government-specified changes to any account unless the customer has taken some step in the past three months to either alter the investments or to reaffirm a desire to keep the account unchanged.
- I generated one stronger and detailed version of that idea, but it seems foolish enough that I’ve banished it to [this footnote] so that I feel slightly less responsible for proposing it.
- Public shaming of procrastinators. Unfortunately, this creates a risk of being used by people to signal wealth (E.g. an implicit message of “I’m wealthy enough that I can afford to ignore the extra $1000/year I’d get by investing wisely”).
- Rating banks and brokers by the ease with which newbies can make certain sensible changes, in order to minimize both actual transaction costs and strange overestimates of transaction costs.
This isn’t the kind of project that governments come close to implementing well. If it can be done at all, it would probably need to be done by a new nonprofit, whose ability to attract donations would depend on producing results that look informative. And even if implemented well, it will have significant problems convincing procrastinating consumers to pay attention to it.
This advice has little chance of being implemented well, because the people who are most interested in controlling the policy implementations are those who don’t believe the average person is capable of acting responsibly. There’s a bit of tension between the goal of nudging people to feel responsible, and the belief that people will normally make irresponsible choices.
And because people who would be annoyed by the policy changes seem likely to be more vocal than those who enjoy them.
Which means, of course, that we don’t need to worry that our habit of signaling our virtue by advocating such policies will be rendered obsolete by success. Yay! Continuing opportunities for cheap talk!
 – When that was written, banks commonly offered returns of 5% per year. Investment choices today are less attractive. The change says something odd about macroeconomic policy.
The author might be influenced by a desire to prove that behavioral economics is more accurate than standard rational actor models. But the phenomenon is too widespread to be explained by such special-purpose motives.
[this footnote] – Banks and brokers could be required to insist that any “inactive” accounts (by which I mean accounts with no change in where the assets are invested) have their status reaffirmed (yearly?) by an explicit statement from the owner that the owner has decided that they want to continue the same investment strategy.
But my mind gets a bit fuzzy when I try to clarify what should happen to people who procrastinate about such reaffirmations. I wouldn’t want the broker to benefit from financial penalties imposed on such people – that would reward brokers for getting customers to ignore the requirement.
Having the government fine customers who don’t comply would improve on that. But that could motivate the government to set the penalty at an undesirable level. And I’m not optimistic about the existence of a desirable level for such a penalty.
How about requiring the bank or broker to return the assets to the customers who don’t reaffirm their strategy? I’m guessing that would work for many people, but there would still be many people who end up with stock certificates getting lost in their home. And returning cash would be messy – doing it by sending a check would defeat the purpose – it would presumably require actual delivery of currency. But banks and brokers would be fairly motivated to get their customers to reaffirm. Possibly by finding ways of defeating the purpose of getting the customers to feel responsible.