Indexing As A Cure For Human Nature

October 16, 2009

Why indexing can help protect investors from their own natural, but misguided, impulses.

 

People are funny. Here we are in the midst of a particularly volatile and treacherous market. The economic news is generally bleak and the political situation deteriorating. Despite those facts, risky securities (having recently produced huge profits) are now attracting the public’s attention. But only seven months ago, avoiding risk was the average investor’s No. 1 objective (and probably Nos. 2 and 3 as well). Even securities that would be considered conservative under normal circumstances had become objects of worry and fear.

KentGrealish_ColumnWhenever we talk about long-term investment objectives, clients generally tell us that they are looking for reasonable returns without big risks. But once the market is on a tear, these conversations tend to be forgotten as emotions take control.

That is to be expected. People make decisions based primarily on either emotion or reason, and emotion is by far the more powerful stimulus. So what we need is an investment strategy that will protect us from being distracted by our feelings. Indexing provides that protection by limiting emotional involvement in the decision-making process.

This conflict between emotion and reason is really a struggle between our inherent human nature (our instincts) and common sense (what we have learned)—feelings vs. facts. The problem is that it is a decidedly lopsided battle since human nature generally prevails. Visceral trumps cerebral.

Polar Opposites

While few people would admit to making investment decisions that are anything other than coldly rational, the evidence simply doesn’t bear this out. We all know that the fundamental rule of successful investing is “buy low, sell high.” Yet our behavior at market tops and bottoms is exactly the opposite. We are wildly enthusiastic and confident at market tops and despondent at market bottoms. We just can’t seem to help ourselves. And this is true for amateurs and professionals alike (although I am sure to get a boatload of emails from professionals telling me how they are the exception).

One explanation for why human nature usually overcomes common sense is that many times we are simply not aware that the conflict even exists. Once we develop the unconscious emotional desire to own a stock, it doesn’t take long to find a “rational” reason to buy it. Consider all of the supposedly logical reasons to buy those “dot-bombs” back in 1999. These companies were hemorrhaging money with laughable business plans and legions of competitors waiting in the wings. Even so, the securities analysts at the top brokerage firms were generally bullish. And when a company reported larger-than-expected quarterly losses, the stock price, more times than not, went … up!

To have acted rationally at the time would have been to miss out on the gravy train—not to mention being thought a fool for your trouble. Man is, after all, a social animal, and when everyone at the cocktail party is bragging about owning the “new, new thing,” who wants to be the party pooper? Besides, it’s pretty hard to fight the crowd when they are the ones getting rich. So it’s understandable that human nature would trump common sense under those circumstances.

 

 

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:

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