Indexing As A Cure For Human Nature

October 16, 2009

 

A big part of the problem is that we are psychologically hard-wired to buy high and sell low. The longer a trend is in play, the more confident we become that it will continue—if not indefinitely, then at least until we get a clear signal that the trend is over. That these signals never appear (except retrospectively) doesn’t bother us—this time will be different.

That’s because overconfidence is in our DNA. Pre-humans needed that trait to coax them out of the safety of the trees and onto the dangerous savannas. But overconfidence and the securities markets can be a dangerous combination.

The trick is to take the emotion out of the decision-making process. We need to protect ourselves from our normal inclination to give in to our feelings, and that is where indexing can be an important safeguard.

Not that it is perfect. Active managers will be quick to point out that indexing guarantees that you will automatically own too much of any overvalued sector. While this is certainly true, the appropriate response is: “What is a realistic alternative?” Avoiding or even underweighting the hot sector may reduce portfolio risk, but under-performing the market is not a winning strategy for an active manager. Any active manager who pulled in his horns when Alan Greenspan called the market “irrationally exuberant” in late 1996 was not likely to still be around when the market finally turned “rational” in 2000.

Hope Springs Eternal

The assumption that an active manager can somehow stay with the trend while it is profitable and know when to get out when things change is, as Samuel Johnson said of second marriages, “the triumph of hope over experience.”

Indexing is a strategy that accepts the futility of timing the market—that there is no reliable system for participating in the good markets while avoiding the bad. Instead, indexing addresses one problem that can be controlled: emotional decision-making.

It seems clear to me that the biggest obstacle to successful investing is our own human nature. Indexing may have its faults, but it can still help protect us from our own natural, but misguided, impulses.

 


Kent Grealish is a partner at Quacera Capital Management, a fee-only advisory firm. He welcomes comments and suggestions for future columns at:

[email protected]

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