Investing can be emotional, especially during 2008. This makes it a perfect time to review how following our emotions can lead to bad investment decisions, sapping long-term portfolio performance.
Behavioral finance studies the psychology of investing and one of the early pioneers in this field is Hersh Shefrin of Santa Clara University. By studying how people think about financial decisions, Shefrin and other researchers discovered important principles that help individual and institutional investors avoid making mistakes that may seem logical, but can ultimately be detrimental to their portfolio performance. Fear, greed and overconfidence are powerful emotions that cloud rational thinking. Here are just a few mistakes researchers have consistently found that most investors make:
Herd mentality. Investors often follow what they read in the media. This certainly sounds like logical behavior, but it can work against you. As an example, John has been watching stocks outperform his bond portfolio during the recent market rally. His friends at work share stories of how much money they made on various stocks, so he decides to "invest" some of his own money in stocks. (Actually John thinks he is investing, but as you will see, he is really just speculating.) Over the course of the next couple years, John will likely see a market downturn. He doesn't worry too much about it until his portfolio falls 10 percent below where he bought it. Soon all the media is reporting how bad the stock market is, and the future is bleak. John's friends finally let on that they started dumping their stocks 3 months ago. In a panic, John logs onto the internet and sells his stock. What did John just do? He bought high and sold low, a recipe for losing money every time. John is frustrated with the stock market.
If herd mentality was an isolated problem it wouldn't matter to us. The reality is that there is empirical evidence that this problem abounds -- by looking at mutual fund cash flows. Numerous studies have found that mutual funds experience a net in-flow of cash after the stock market has been rising, and a net out-flow after the market has fallen. Aside from short-term cash needs, an investor is far better off with a buy-and-hold strategy than trying to time the market. Herd mentality causes people to buy near the top and to sell near the bottom.
Loss Aversion. For most investors losing 10 percent is much more painful than the joy and excitement of earning 10 percent. This causes people to become more conservative in their portfolios as their portfolio declines. However, the best returns come early in a market rebound and missing just a few days in the rebound results in significantly diminished returns. For example, if Sarah invested $1,000 in an S&P 500 index fund on January 1, 1970 and held it until December 31, 2007 it would be worth $54,118 for an annualized compound return of 11.07 percent. However, if during this same 38 year time period Sarah missed just the fifteen best days in the market, her $1,000 investment would be worth a mere $25,217 with an annualized compound return of 8.86%. The single best day during this 38 year time horizon was a 9.1 percent return on October 21, 1987, just two days after the October 19th crash. How many investors who bailed on Monday October 19 would have been ready to buy back the very next day? Probably none. Actually, this example underestimates the problem because it doesn't take into account having to pay capital gains taxes when selling. While investors who have an aversion to losses think they can beat the market by getting out of the stock market when it's going down, and jumping back in when it's rising, research shows otherwise.
Loss aversion also leads people to hold onto losing stocks in individual companies longer than they should. Sometimes a company is a bad investment, but taking a loss is often felt as having made a bad decision and is a blow to the ego. Selling admits defeat, while holding on is a sign of confidence in the original decision to buy that stock. Even though the right thing to do may be to sell that company, accept the loss, and re-invest in another company, most people avoid selling at a loss.
Chasing Hot Performance and Overconcentration. Some investors look for the most recent hot investments and put the bulk of their money into that one asset, whether it's real estate or energy stocks. They look at recent performance and extrapolate that to future performance. We've witnessed this in the recent real estate market crash, after speculators saw rapidly rising real estate prices and easy money. Many thought real estate prices would continue their meteoric price rise based on their performance since 2002. Of course reality is setting in -- the average U.S. home prices plummeted 7.0 percent from May 2005 through April 2008, and prices are still falling. In California prices fell by 23 percent! Meanwhile, stock prices rose 26.78 percent during this period. Similar behavior was seen during the tech boom and tech wreck, and we may yet see a crash in the oil market with the recent runup in prices. Chasing hot performance can lead to a very unhappy ending when the runup is over.
So if all of these seemingly logical behaviors are indeed detrimental how should we invest? By making strategic, long-term allocations to a broadly diversified set of high-quality assets and riding through the ups and downs of each cycle, along with scheduled rebalancing. This produces the most consistent returns with the lowest tax consequences and turnover costs. By working with us to personalize your strategic allocation we can build a wealth portfolio that helps you meet your financial goals and helps you sleep better at night.
For more information on behavioral finance see http://en.wikipedia.org/wiki/Behavioral_economics