What Did The Bear Do To Your Brain?

April 22, 2009

 

Investors should avoid focusing on the performance of one investment or one asset class in isolation. For example, if we have a combination of fixed income and equities, it is better for us to focus on the combined performance of the entire portfolio over a long period of time. This also applies to each account; we should focus on the performance of all our accounts combined. Further, investors should include all of their assets (both liquid and less liquid assets) and the effect on their total net worth over time rather than the amount of decline experienced over a very short period of time in one section of their net worth (like the piece invested in the market) or one subasset class (like emerging markets). Diversification needs time to work and it does not work perfectly in every one-year (or less) time period.

However, it works well over long periods of time so investors should stay focused on the bigger picture when going through difficult markets. Your investment strategy is likely the result of a combination of short-, intermediate- and long-term goals. It may be tough to keep that in mind when investments are mixed in a way that combines all of those goals.

3) Anchoring Tendencies

Investors often tend to latch on to a specific reference point when making decisions even though the reference point has no relevance. For example, investors have the tendency to use the original purchase price of a fund as a reference point when making future decisions about selling or holding the fund. They fail to realize that the market and the fund do not care what the investor paid for it in the past as it has little relevance to the real value now.

During declining markets, investors tend to anchor on the peak value their portfolio reached. Investment declines are calculated from the peak point, not from a specific time period in the past. Anchoring in this way may cause severe emotional reactions.

The best way for investors to counter this behavior is to inspect portfolio values over specific longer-term time intervals instead of high and low points. Rather than checking portfolios daily, weekly or even monthly, investors should make an effort to wait for their statements to arrive. Research has shown that individuals who check their accounts more frequently tend to trade more frequently and also tend to generate lower returns.

It is best to examine the returns of an investment strategy over the past several years and where possible, over an investment lifetime. For investors that have not been investing for long it is worth examining the long-term historical data on diversified portfolios.

Another strategy is to examine gains or losses in the context of total net worth changes over longer periods of time. For example, a person who has seen their $500,000 portfolio decline 30% from the high point (a $150,000 decline) may be prone to panic by focusing on a loss of $150,000. If their premarket decline total net worth was $1,000,000 before the market decline, the percentage decline is cut in half. Also, if they looked at the change in their total net worth over the last five to 10 years, they may find losses are even less severe than previously thought.

4) Gambler's Fallacy (Law Of Small Numbers)

Research shows that people place too much emphasis on a few witnessed observations when making predictions about future outcomes. We believe trends are apparent where they do not exist, and this leads to chasing performance among other poor investment decisions. Our minds are adapted to making quick reflexive decisions because for most of our existence we had to avoid dangers and seek opportunities for food with little time for calculation.

In any random string of events guided by probability, you will see many streaks over short intervals. Statisticians explain that the oddity is when you do not see streaks occur. It is over large numbers of trials that results gravitate toward the expected probability, with many streaks and breaks from the long-term odds occurring over short intervals.

 

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