“Men nearly always follow the tracks made by others and proceed in their affairs by imitation.” – Niccolo Machiavelli
Investment decisions are among the most important life choices a person can make. They may determine where your children will be able to go to college, when you’ll be able to retire, or what kind of lifestyle you’ll enjoy after you retire.
Unfortunately, these are also some of the most difficult choices a person can make. This is especially true now as we work our way through arguably the worst financial crisis of our lifetime. In order to make sound decisions, we need to be aware of our own psychological blind spots. These can lead us to make persistently poor financial choices—errors that over time can do significant damage to our portfolios.
Traditional financial theory assumes all investment decisions are made rationally, based on the best available information. However, it’s not always easy to reconcile financial theory with financial reality. Investors often appear determined to ignore the fundamentals, both in bidding stock prices up and slamming them back down again.
The desire to experience a positive outcome often prompts us to imitate the actions and behaviors of others. This refers to “herd behavior,” the tendency for people to mimic the actions of a larger group of investors. Recent examples of this include the money that poured into real estate in 2005 and the late 1990s technology bubble. Before this, it was the same story for energy stocks in the early 1980s, following skyrocketing oil prices in 1979. And now? The herd is putting money into CDs and other short-term cash equivalents. We know how this story will likely end.
To quote Warren Buffett from his op-ed piece in the October 17th, 2008 New York Times:
“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.” Warren Buffet’s un-herd-like mantra for investing is to “Be fearful when others are greedy, and be greedy when others are fearful.”
Richard Thaler, a professor at the University of Chicago and a leading behavioral finance researcher notes, “In many important ways, real financial markets do not resemble the ones we would imagine if we only read finance textbooks.”
It’s not that investors are totally irrational, Thaler and other researchers argue, but rather that their thinking can be influenced by mental biases. These quirks can lead them
to make choices that appear intuitively correct, but produce poor performance:
• Overconfidence. Investors generally assume they know more than they actually do. They also tend to remember previous investment decisions in ways that exaggerate their own foresight. This can lead to overly aggressive trading and a reluctance to admit—and correct—mistakes.
• Mental Accounting. Financial experts often advise investors to take their entire portfolio into account when making investment decisions. Yet, many investors unconsciously divide their wealth into separate pots. If they have a big gain, for example, they may think of it as essentially “free” money and take greater risks with it than they would with their “own” money.
• Anchoring. Logically, investors should always base their decisions on current prices and expectations. Instead, they often become fixed on past events, such as the price paid for a particular stock. Investors will often refuse to sell at a price lower than that—even when it makes more sense to accept their loss and invest their remaining money elsewhere.
• Framing. How people view a decision often depends on how their choices are presented. For example, in one study researchers asked participants how much they would be willing to pay to avoid a one-in-a-thousand chance of being killed. The average answer was $1,000. Participants were then asked how much they would demand to accept the same risk. This time, the answers ranged as high as $200,000. From an economic point of view, the two questions were identical, but subjects saw them very differently.
• Loss Aversion. In a completely rational market, the risk of loss and the possibility of gain should carry equal weight. However, on average investors place twice as much
importance on avoiding a loss as they do on making a gain. In other words, to accept a 50% chance of losing $100, most people will demand at least a 50% chance of earning $200.
The Value of Advice
Are investors doomed to repeat these mistakes? Maybe not. Some studies have shown that the more investors know about the investment process, the less likely they are to be misled by behavioral biases.
My best advice to investors during this time? I encourage you to develop a Financial Plan, as well as prudent, long-term investment strategies that take into account your goals and tolerance for risk. Do not try to time the market. I’ve never seen anyone do it with success. Stay invested and rebalance as needed. The ensuing rally from the bottom of the last nine recessions since 1950 has averaged 33%. And the markets traditionally begin their ascent 9 months before the end of a recession. At this point, the biggest risk is missing the move. And Turn off CNBC.
While this doesn’t guarantee investment success, it can at least reduce the risk of being led astray by behavioral blind spots. That’s something even the smartest investor might want to keep in mind.
For information on investing in these volatile times, please visit my web-site at www.fa.smithbarney.com/benproctor for regularly updated investor-friendly reports, including the 100 Point Commentary Letter that is generated whenever the markets move more than 100 points in any direction.
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