You sit at a table next to a wooden wall and the experimenter gives you the materials shown to the left: a candle, some tacks, and a box of matches. Your job is to fix the candle to the wall so that the wax doesn’t drop on the table. Think for a moment about how you’d solve the problem.     – “Drive”, Daniel H. Pink

STOP! Before you continue, take a minute to think about the problem and see what you come up with.

This experiment was conducted by a psychologist named Karl Duncker to see how fast people could solve a problem that took creativity. One group earned nothing; the other was incented based on speed. The faster they could solve it, the more money they got.

How did the incented group perform compared to the ones who did not get paid? It took the incented group three and a half minutes longer than the ones who did not get paid. That’s right, it took longer!

The experiment concluded that rewards narrow our focus, which is helpful when there’s a clear path to a solution. But when creativity is required, the narrow focus blinds people from the wide view that might have allowed them to see new uses for old objects.

This cognitive bias is called “functional fixedness” which limits how a person uses an object in a new way to solve a problem. It’s also known as Maslow’s golden hammer: “It is tempting, if the only tool you have is a hammer, to treat everything like a nail.”

This bias correlates to investors as well. Think about how volatile the markets are, how negative and sensationalist the news is, and how there are times when no good news is in sight. All the while, your portfolio’s value has temporarily gone down.

Now imagine you are presented with this problem: what is ONE thing you can do to increase portfolio returns?

What did your mind race towards? Asset allocation. Diversification. Day trading. Pick hot companies. Look for companies whose price is down. Etc.

In this scenario, you clearly have different ‘objects’ available to you and you have a strong incentive.

However, when looking for ways to increase portfolio returns, people fixate on the function of what is within the portfolio, and they forget about what they can do to the portfolio.

The solution is simple: add new money.

Now that’s not to say those other functions of investment strategy aren’t important. Once you have a well diversified portfolio that is actively monitored, you have to look outside the portfolio to outperform.

To illustrate just how important your behavior is to affecting returns, we ran three different scenarios of investor behavior during the Great Depression.

(Our current situation isn’t a depression; we just used that to back-test assumptions and illustrate impact.)

Take a look at the graph to see how these three people behaved during the Great Depression, and what resulted.

One client added money, one did nothing, and one withdrew money. Look at the difference in actual portfolio returns (gains) between each and notice how the only one to increase portfolio value was the one who added money throughout the downturn.

You can change the amounts, but the fact remains: adding money during downturns increases returns.

So that’s what you should do but we all know that this isn’t what people really do. As experts in behavioral psychology and economics, we decided to analyze our own clients to measure the effectiveness of our advice.

Did we motivate clients to behave in their best interests?

Here are the year-to-date results for all our clients, broken down by those who are more risky (Growth) and those who are risk averse (Conserve):

As you can see, the majority of our growth-oriented clients added money during the downturn.

For those who did not, they can see that this has consequences, and while not adding money is the mistake of the masses, it’s not what most of their enlightened client peers are doing.

Conservative clients are typically near or in retirement. Interestingly, an equal amount of those clients added money or remained neutral.

Nearly a third of these clients withdrew money and that is also expected for those in retirement, as they have more conservative portfolios and less impact during downturns.

This is a result of effective advice, thorough planning, and taking action.

Back to the Candle Problem (you didn’t think we would forget to tell you the answer?). Most people try at first to pin the candle to the wall or light the candle to melt the wax and affix it to the wall.

After five or ten minutes, they realized that they must empty the tacks from the box, affix the box to the wall, and place the candle inside the box.

Remember, your behavior is the number one determinant in earning real investment returns.