Investors need to stop listening to their irrational impulses, have a plan and stick to it, Roth says.
It’s well known that investors, individuals and professionals alike chase performance.
The predictability and consistency of this buying-high-and-selling-low behavior can be seen in stock market trending. For example, investor cash flows continued to flow out of stock mutual funds and ETFs from the 2008 plunge until January 2013, when U.S. stocks hit an all-time high.
But it’s the why investors performance-chase that ends up being the elephant in the room.
I have yet to hear a single investor come to me and confess that the reason she wants to buy now that stocks are at an all-time high is because she’s greedy. Nor has a single investor told me that his decision to bail out of the market during the 2008-2009 plunge was because of a massive panic attack.
Further, I know I’m never going to hear such a confession. Nobody wants to admit they allowed their emotions to take the wheel when making investment decisions. Instead, investors come up with sophisticated reasons to explain and justify those decisions. And with the stock market surging, here are a few I’ve heard recently:
“I need to increase my equity exposure as I have too much risk in U.S. Treasurys.”
“Interest rates are sure to surge and the bond bubble is sure to pop, making bonds the riskiest investment of all.”
Let’s delve a little deeper into that logic, shall we?
First, I’m pretty darn sure that if the U.S. Treasury market goes belly up, owning stocks won’t diversify the risk inherent in that scenario.
Second, that bond bubble has been predicted for some time now, and by the same top economists who have less than a 50 percent track record of predicting the direction of longer-term interest rates. Stocks are riskier in a day than high-quality bonds are in a year.
Over the past five years, I’ve heard all sorts of reasons to panic.
“Never before has a whole financial system needed a bail out. It’s a ‘new normal’ and stocks will become worthless. Only government securities will have value.”
“Paper currencies will be worthless. Gold will be the only currency with value.”
“Only emerging market countries are fiscally sound, and investing in those countries will surely outpace the fiscally irresponsible U.S. and Western European countries.”
As it happened, stocks did recover; gold didn’t go up forever; and emerging market equities badly underperformed, just as billions of dollars poured in to those funds.
Personally, I always thought the possibility that I would be required to go grocery shopping with gold was a bit far-fetched.
I admit that much of this sophisticated reasoning—the 2008 fleeing from stocks and the long fear-based aversion to re-enter the market—makes sense to me and, at the time, my own instincts were telling me similar foolish things. That’s why instincts are so dangerous when it comes to investing.
Jason Zweig’s book, Your Money and Your Brain (Simon and Schuster 2007), explains that we have two brains. One is a thinking brain, which he calls the reflective brain, while the other is a feeling brain, which he calls the reflexive brain. Zweig notes it’s hard to know which brain is actually driving our thoughts.
In each of the not-so-logical assessments above, it’s our reflexive brain at play, driven either by the desire to get rich or the fear of losing it all. To justify acting on these emotions, we call upon our reflective brain to come up with a sophisticated justification for performance-chasing.
Breaking this cycle is no easy task.
The best way I know is to stick with a plan come hell or high water. Committing to an asset allocation requires that one must buy when the herd is coming up with sophisticated reasons to sell, and vice versa.
Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.