Stages of Investing Generated Using the Model of Hierarchical Complexity

Stage 10 As developmental stage increases, individuals possess the skills, knowledge, and understanding of the lower stages, as well as a new set of skills, knowledge, and understanding that allow the jump to the higher stage. At the Abstract Stage 10, the decision-making process on investment strategy is heavily influenced by outside sources. A person at the Abstract Stage follows the crowd as they buy low and sell high because that is what others are doing. They listen to others to find a “highly rated” investment advisor and then do what their advisor says no matter what the performance. This directly leads to large fees, low returns, and a high likelihood of losing money. They do not yet understand ratios and percentages in the context of interest rates and percent fees on mutual funds, nor do they understand percent inflation and why the return on bonds may not keep up with inflation. The “Wealth Effect” (Darby, 1987; Jelveh, 2008; Zubin, 2008) is an economic term where an increase in perceived or actual wealth leads to an increase in spending, or vice versa with a perceived or actual decrease in wealth. Temporary wealth changes have a smaller effect on consumption changes than permanent wealth changes. With the wealth effect people psychologically associate higher net worth with having more disposable income. This is evident at Abstract Stage 9 where big gains in portfolio values attributable to bull markets make people feel secure about their wealth, so they spend more of it. At this stage, people tend to invest more at the height of markets and overconfidence, caused by the wealth effect, leads to bigger losses when the market crashes. People also pull money out at the bottom of the market. They make overcorrections that are similar to those made by novice sailors. If one tries to turn too quickly, one will find that most times one ends up turning too far across the wind. One’s instinctive reaction is to turn back the other direction, most times ending up head to the wind instead. The process of overcorrecting, both in investing and on the water, is the result of riskaversion. This leads to smaller overall gains when the markets go backup. If the wealth effect is too strong, meaning people overcorrect for changes in the markets by selling too much when the prices are low and buying too much when the prices are high.